What is leverage? Understanding borrowed money for trading

Using Leverage to Boost Your Trading Power

In the trading world, the term “leverage” refers to controlling a position with a large value while only using a small amount of your own capital. This technique allows traders to amplify their trading potential by borrowing money from the broker.

For example, if you want to trade $100,000 but only have $1,000 in capital, the broker will lend you the remaining amount at a ratio of 1:100, meaning the required margin(is 1% of the total value.

What is Margin and How Does Leverage Relate?

Margin, or collateral, is the amount the broker deducts from your account to serve as a guarantee for your trades. Generally, brokers offer various leverage ratios, from 1:1 up to 1:500, with each ratio requiring different margin levels.

The table below clearly shows the relationship between margin and leverage:

Practical Example: How Margin Works in Trading

Imagine you want to trade EUR/USD when the price is at 1.26837 and decide to open a 1-lot position )100,000 units(. The total value of the position is 1.26837 × 100,000 = $126,837.

Case 1: Trading with 1:200 leverage

If you choose to use 1:200 leverage, the broker will deduct only 0.5% as margin, which equals $634.19.

Case 2: Trading without leverage )1:1(

If you trade without leverage, you need the full amount of $126,837 in your account.

How Do Profit and Loss Differ?

Suppose the EUR/USD price increases by 3 pips from 1.26837 to 1.26867. The profit in dollars will be the same )$130(, regardless of whether you use leverage or not.

As you can see, although the profit in currency is the same, the percentage profit differs greatly. Using 1:200 leverage, your profit can reach 20% of the capital used, which is much higher than the 0.1% in the no-leverage case.

Similarly, if the price drops by 3 pips to 1.26807, you will incur a loss )in both cases(. However, when calculated as a percentage, the loss will be significantly higher.

Leverage Is a Double-Edged Sword

A common phrase in finance states that “leverage is a double-edged sword.” This is an accurate description. Leverage can magnify your profits tremendously, but it can also amplify your losses.

You must understand that trading with leverage requires strict risk management because small price movements can quickly wipe out your account.

In Short

Leverage, or trading with margin, is a mechanism that allows traders to increase potential risk and expected profits. Brokers often offer various leverage options, from 1:1 up to 1:500, depending on their policies. When you understand how leverage and margin work correctly, you can make informed decisions about using leverage wisely. Remember, it is a double-edged tool that must be used with caution.