Leverage definition

Leverage is an investment strategy that uses borrowed funds to gain exposure to larger trading positions. Leveraged trading is also known as margin trading. The aim of using leverage in trading is to increase the exposure of a trading position to increase potential returns from a trade. However, leverage also magnifies the potential risk should the markets go against a trader’s predictions. Leverage can be used across a variety of financial instruments and markets, such as indices, stocks, commodities, forex, and Exchange-Traded Funds (ETFs), to name a few.

Leverage can be used by both companies and individual investors. Retail investors use leverage to increase potential returns from their investments. Companies can also use leverage to finance their assets. Instead of issuing stock to raise funds for operations, companies can instead use debt financing to fund their business operations.

When trading using leverage, a provider will only ask investors for a fraction of the total value of their position. The rest will be lent by the provider instead. Nevertheless, any profit and losses will depend on the total size of your position, which is why losses may end up exceeding your initial deposit.

Advantages of leverage

Leverage is used primarily to amplify potential profits. Additionally, using leverage allows traders to control a larger amount of capital than they would otherwise have access to with their available funds. Leverage can also be used in short-term low-risk situations. Instead of using additional capital, traders can execute trades at opportune moments with the intention of existing their leveraged position quickly.

Limitations of leverage

Leveraged trading generally carries more risk, as it involves traders opening bigger positions with greater exposure to the market. While traders may be able to make more substantial profits, they may also face more substantial losses if the markets go against their predictions.

Risk management for leverage

One popular risk-management tool when trading with leverage is a stop loss. By using a stop-loss order, it can help to limit potential losses if the market moves in an unfavourable direction. However, do note that basic stop losses are still susceptible to market slippage and gapping.

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See related entries from our knowledge base:

Leveraged trading strategies

Guide to leveraged trading