Leverage trading allows traders to control a large market position with relatively little capital. While this may seem attractive at first glance, it significantly increases the level of risk.
This article explains in clear terms how leverage works, the role of borrowed capital, and why even small price movements can have a major impact on your trading account.
What Does Leverage Mean in Trading?
Leverage describes the relationship between your own capital and the total market position you control.
A leverage ratio of 1:10 means that only 10% of the total position size must be provided as your own capital.
With $1,000 in capital, a trader can therefore control a position worth $10,000.
The remaining amount is provided by the broker as borrowed capital. This borrowed capital is not free of charge and may generate costs, for example through swap fees, which are explained further below.
The higher the leverage, the smaller the required capital in relation to the total position – and the stronger the effect of price movements.
How Does Leverage Work Technically?
When trading with leverage, traders deposit a security amount known as margin. This margin serves as collateral for the broker.
The leverage ratio determines how large the market position is compared to the deposited margin.
A leverage of 1:100 means:
- $1,000 own capital
- $100,000 position size
Even small price movements now affect the full $100,000 position – not just the $1,000 invested.
Example: Gold Trading with 1:100 Leverage
Why leverage trading is not easy money but involves substantial risk can be illustrated with a simple example.
Assume a trader opens a gold position with $1,000 in capital and a leverage of 1:100.
- Capital: $1,000
- Leverage: 1:100
- Position size: $100,000
If the gold price falls by 1%, this results in a loss of $1,000 on the total position.
This would mathematically correspond to a complete loss of the invested capital.
Why Does Leverage Increase Risk?
Leverage does not create price movements. It amplifies their impact.
Even small market fluctuations can lead to significant losses. In volatile markets, this can happen very quickly.
Margin Call and Stop-Out
Brokers continuously monitor the ratio between account equity and open positions.
If account equity falls below a certain threshold, a margin call may occur. If losses continue, positions can be automatically closed at the stop-out level.
This mechanism limits further losses but also means that losses are realized.
What Costs Are Associated with Leverage Trading?
- Spreads
- Commissions
- Swap fees (overnight financing costs)
In forex trading, swap rates may be positive due to interest rate differentials. However, this often does not offset exchange rate risk.
Conclusion
Leverage enables traders to control large positions with limited capital. At the same time, it significantly increases risk.
Leverage trading involves substantial risk and is not suitable for every investor.