What leverage is really all about

I brought up the topic of leverage a couple months ago in my post How much leverage to use? Wrong question! The general topic of leverage, though, continues to be much misunderstood, so let me take some time to back it down to the basics.

Leverage the control of a position larger than your own funds would directly allow. It’s available in one form or another in basically every market and is accomplished either through borrowing and/or the use of derivatives.

You will see things like 50:1 leverage or 100:1 leverage. A 100:1 leverage ratio means that for every $100 in position value you would be required to put up $1 in deposited funds.

Now margin is closely tied to leverage. Margin is the deposit money used to secure a leveraged position. It is normally expressed in percentages. For example the margin on a position when employing 100:1 leverage would be 1%. At 50:1 leverage it would be 2%. An so on.

There is the additional topic of gearing or effective leverage or real leverage. Those are just different ways of talking about the actual leverage one employs when holding a position. For example, you may be able to trade at 100:1 leverage but if you have a $10,000 account and are trading a $100,000 position you are actually only using 10:1 leverage – meaning your are only controlling a trade 10 times the size of your account.

I think most people get that part of it all.

Here’s where the confusion comes in. I have seen a number of traders say that leverage equals risk. This simply isn’t true. What is boils down to is this. Allowable leverage tells you one thing – how big you can trade, either in terms of position size or number of positions. That’s it. No more. No less.

Risk comes down to one thing, and one thing only – the size of your position. The larger the position, the greater the risk. It’s that simple, really. High degrees of available leverage certainly allow for larger positions, but they do no require them.

The thing that I think causes the most confusion is thinking in terms of margin and not account size. If you trade at 100:1 leverage you would have to put up 1% margin. That means a 1% move in the market against you would wipe out your margin deposit. If you were trading on 50:1 leverage the same 1% move against your trade would only take out half your margin. That seems like less risk.

Here’s why it isn’t.

Assume a $10,000 account and a $100,000 trade size. For a 100:1 leverage account the margin requirement would be $1000, while at 50:1 it would be $2000. If the market moves against the position by 1%, that would mean a $1000 loss to the account, or a 10% decline in account value. It doesn’t matter whether the trade was done in a 100:1 or 50:1 leverage account. A 1% move on a $100,000 position will always represent a 10% change in account value for a $10,000 account.

The only time differences in leverage mean differences in risk is when you are talking about different position sizes, basically meaning using all available funds for margin. The 100:1 leverage $10,000Â account could trade $1 million, while the 50:1 could only go as high as $500,000. Clearly, when the accounts are maxed out like that a 1% move in position value is different. The 100:1 account would be wiped out, while the 50:1 account would only lose have its value.

I hope that clarifies things a bit. Feel free to comment with your own thoughts and/or questions.

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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
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