Leverage works like a lever, allowing us to move more capital than we have invested in financial markets.
Leverage is one of the principal concepts used in trading.
Its structure is the same as when we ask for financial credit. The financial institution lends you its capital for which they will charge you interests and they will ask for some guarantees during the credit life cycle.
A financial credit is applied on trading platforms, with the difference that these credits occur immediately upon opening an order.
Not all the assets or brokers offer leverage. Here you have a list according to typology:
Assets with leverage
- Futures
- Options
- Warrants
- Forex
- CFD
Assets without leverage
- Monetary and deposits
- Bonds
- Shares
- ETF
- Funds
How does leverage work? #
To understand leverage we must have three concepts clear: balance, equity, and free margin.
The balance and equity of an account refer to the result we have in the account. This result should be distinguished in two ways. The one we have materialized in our account, which is the balance, and the one we have latent according to the profits and losses of our operations, which is the equity.
Example, an account where someone has deposited €1,000, this is the balance.
If there is no open operation in the market, then equity will also be €1,000.
Later on, we open an operation in which we have losses of €150. Here our equity will be lower than the balance due to our losses.
Equity €1.000 – €150 = €850.
Furthermore, when we open a market operation, it is required a margin of €200 (the equivalent of the guarantee when we ask for a credit loan). Our margin will be lower than our equity because the operation required a margin that we have deposited at the broker. Margin €850 -€200 = €650.
If we want to open more orders with leverage, we cannot surpass our margin limit. If our orders were to have losses, exhausting our margin, that would cause us to enter into Margin Call, where the broker must close our orders due to lack of collateral.
When we close an open operation the retained margin is returned to the account.
Leverage: a double-edged sword #
Leverage is a very powerful tool but not all are benefits.
A trader with €3,333.33, operating with his broker which offers him leverage of x30 could move 1 set of EURUSD, which means moving €100,000 in the market.
If we have understood the previous section, we will understand that the trader now has more balance in his account, in order to have a disposable margin after retaining the €3,333.33 of guarantees and holding its position.
In the case that EURUSD rises a 10%, which would mean a profit of €10,000 for each set. With leverage, our trader has now €13,333.33 with a profit of 300%.
However, if the EURUSD had dropped only a 3.5% that would mean a loss of €3,500, so the trader would have already lost more than a 100% of the margin deposited for the order.
Leverage limitations in Europe #
Given the importance of knowing properly the leverage concept before their usage and the lack of existent formation in traders, ESMA (European Securities Market Authority) decided in 2018 to limit leverage levels for European brokers.
These are the actual limitations depending on the assets:
- Leverage x30 in FOREX (margin 3.33 %)
- Leverage x20 in CFD on indexes (margin 5 %)
- Leverage x10 in CFD on raw materials (margin 10 %)
- Leverage x5 in CFD on shares (margin 20 %)
Conclusions #
As Pirelli said in his slogan in the 95: “Power is nothing without control”.
That is what happens with leverage, is a powerful weapon that you have to know and use with the appropriate knowledge and abilities.
The most important thing for responsible trading is knowing how to do it, learning, and, above all, validating strategies before investing.
