Leverage is the proverbial double-edged sword of trading. It's your friend when the market moves with you and your foe when the market is against you. To appreciate this relationship, one needs to first look at what leverage is.
What Is Leverage?
Leverage allows an investor to gain a greater exposure than his investment would normally command. This is also known as margin trading. The system minimizes the amount of capital the trader has to invest. Instead of paying the full price for an instrument, the trader can pay only a small portion of it. For example – if a position’s value at the time of opening is $2,000; instead of paying the full amount, the trade uses a leverage of 20:1 – meaning for every $ 20 of exposure, they will be requested to invest $1 of their own capital. This mean that for this position, they will only need GBP 100 to open it.
Differences Between Leverage and Margin
Margin and leverage are different but have a direct relationship. As mentioned previously, Leverage is expressed as a ratio, e.g. 20:1. Margin, however, is expressed as a %, and the amount of margin required actually defines the leverage. If one was to consider the leverage as a loan from the broker, then the margin would be the collateral required to maintain that loan.
Using the previous example for an investment of $2,000, the trader would have to put down $100 which would be the margin.
The leverage is:
2000/100 = 20
and the margin would be:
100/2000 = 0.05
or expressed as a %,
which will be 100/2000x100= 5% in this case.
Different Leverage for Different Traders
Depending on the regulator and the status of the client, the leverage that can be offered differs. If we look at the maximum leverage allowed under the FCA regulations, the leverage that a retail CFD client can have is between 30:1 and 2:1. Furthermore, the actual leverage that a retail trader can have is different from product to product. For example, major currency pairs can be traded with the highest leverage offered to retail traders, which is 30:1, while only 2:1 can be applied to trades involving cryptocurrencies. Here is the list of all leverages offered to retail traders:
30:1 for major currency pairs
20:1 for non-major currency pairs, gold and major indices
10:1 for commodities, non-major equity indices
5:1 for individual equities
2:1 for cryptocurrencies
For professional traders, however, the leverage is greater as this type of traders are presumed to have enough knowledge to not require the protections offered to retail clients. The size of the leverage offered depends on the broker but to use USG UK as a good example of leverage for professionals:
400:1 for major currency pairs
400:1 for non-major currency pairs, major indices, metals
200:1 for commodities
33:1 for shares
20:1 for cryptocurrencies
In conclusion, leverage gives you greater market exposure and therefore increases your potential profits and losses. Always be aware that it works on the way down as well as on the way up.