An analysis of leverage in trading

In the world of trading, leverage is a frequently mentioned term, yet few understand the extent of its mechanics, and potentially devastating effects for the uninformed. Briefly, leverage is a mechanism by which traders can manage a significantly larger position in the market than their actual capital permits them to. While this can substantially increase profit potential, the risk of losses is also further amplified. Throughout this article, we will explore the inner workings of leverage, and highlight the distinctions in its applications between retail traders and professional, institutional users.

What is leverage?

Leverage can be defined as the process of borrowing funds in order to amplify your purchasing power in a market. For example, if you possess £1,000 worth of funds, you can utilise a leverage ratio of 10:1 to trade up to £10,000 worth of stocks. You provide the ‘margin’, the fraction of a total trade value, while the remainder is financed by your broker.

At first glance, this may seem entirely advantageous, as a trade with positive results will garner significantly higher profits. The problem arises in losing trades, where your losses can potentially exceed your initial investment. Not only can you lose your capital, but owe further money to the broker.

Example of leveraged trading

To illustrate the concept of leverage in trading, consider this example:

1, Suppose you trade with £2,000, and choose a leverage position of 5:1, which allows you to control a £10,000 position.

2, If your trade rises by 10%, your profit would amount to £1,000, half of your original capital, compared to £200 without leverage.

3, If the price declines by 10%, your losses would be £1,000.

Leverage can be seen as a magnifier of market movements. It is often described as a double-edged sword. For those who know how to wield it effectively, it can be incredibly powerful – for those who lack the necessary understanding, it poses a significant risk.

Leverage in retail trading

Retail traders are typically individuals who engage in trading on their own, with varying levels of experience and knowledge. For markets such as Forex and Commodities, leverage can be particularly attractive to retail traders, as it enables them to access certain markets which might otherwise have higher costs of entry.

However, all retail trading leverage use is regulated by authorities. In the UK, the Financial Conduct Authority (FCA) limits the amount of leverage available in order to protect retail traders from taking on excessive amounts of risk. These limits are capped by ratios, such as 30:1 for major currency pairs, 20:1 for minor pairs and even lower for stocks and commodities. Similar restrictions exist for retail traders in the US, showing that while retail traders are able to use leverage to enhance their positions, it is not on the same scale available to institutional traders.

Advantages of leverage for retail traders

Leverage allows retail traders to access a broader variety of markets that would have otherwise been unaffordable. Moreover, the use of leverage allows traders to access enhanced returns with smaller capital, requiring a less substantial initial investment

Disadvantages of leverage for retail traders

While the potential of higher returns may be enticing, this comes with an increased risk of loss, which can deplete an account rapidly. A ‘Margin Call’ occurs in a situation when losses have escalated so far that brokers require traders to deposit additional funds, or be forced to liquidate their positions. The risks are significant, and many experts recommend retail traders to begin with lower, more manageable leverage ratios and increase as they become more experienced.

Leverage for elective professional clients

Professional traders, or elective professional clients tend to represent larger institutions, often employed by banks or hedge funds. They most likely possess higher levels of experience and have better access to tools and resources than the average retail trader. With established risk management systems in place, elective professional traders are able to use leverage with greater flexibility.

Professional traders can enjoy access to significantly higher ratios of leverage, compared to the restrictions placed on retail traders. In forex trading, they can access ratios often exceeding 100:1. For short-term movements on currency pairs, seemingly insignificant price movements can be amplified greatly, something particularly appealing for those using shorter time frames in trading. 

Leverage is also used in more sophisticated strategies such as hedging or arbitrage. This allows elective professional clients to capitalise on the price discrepancies across different markets. Of particular interest to the institutions themselves, employing leverage can enhance liquidity, which allows traders to take on larger positions without sinking the firm’s cash reserves.

Advantages of leverage for elective professional traders

Enhanced flexibility in trading allows professionals to quickly modify their positions in response to market changes. Furthermore, the potential applications in sophisticated strategies are particularly effective, especially compared to results achievable with cash alone.

Disadvantages of leverage for elected professionals

Using leverage exposes professionals to a certain level of counterparty risk, such as if brokers or partners fail to meet their obligations, most commonly seen in periods of market volatility. Whilst professional traders are not subject to the same regulatory restrictions as retail traders, regulatory bodies maintain close oversight on leveraged trading activity to mitigate potential risky trading, that could have an impact on the broader economy.

Comparing leverage use: retail vs elected professionals

The main differences between leverage use for retail traders and elected professionals can be split into three categories:

1, Regulation - Retail traders are subject to stricter limitations on leverage ratios, while professionals are trusted with access to the full potential of leverage, being allowed greater flexibility.

2, Risk Management - Professional traders typically have more sophisticated risk management systems in place, while retail traders are limited to simpler stop-loss orders, for example.

3, Access to Capital - Professionals are usually managing much larger accounts, absorbing the impact of losses more effectively than retail accounts.

Different regulators around the world allow different levels of leverage for traders. You can read more about this here.

Conclusion

Leverage is a powerful tool when used correctly, in experienced and knowledgeable hands. It can allow retail traders to participate in the markets with limited initial cost, but carries significant risks if used without care. In the world of the elected professional, leverage is more of a strategic tool – not only enhancing returns, but providing liquidity optimisations, or facilitating more complex financial strategies. Regardless of your status as a retail trader or professional, it is crucial to understand the mechanics of leverage, and to employ a risk management strategy. 

Leverage is not a shortcut for quicker profits, but is something to be used responsibly, and with care.

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Author

Caleb is a financial copywriter with a specialisation in fintech and forex. Former copywriter at Barclays and Paysafe. Contributing writer for LiquidityFinder. You can message Caleb here.