The word leverage has several meanings, that are all distinctly different, and yet still hold some similarities. In science class, you may have likely learned about mechanical leverage. This is used to amplify the physical force that is input using a mechanical tool such as a lever, in order to increase the force that is output. The same concept applies when it comes to Leverage in financial trading.
Leverage is the use of borrowed capital to magnify investments on financial assets. To clarify, an investor is able to trade with more capital than they have invested, in order to amplify their buying power. Using leverage allows a trader a larger return on investment, meaning if the market moves in their favor the profits will be multiplied. The same of course is true if the market moves against the investor, the losses will also be multiplied.
For example, if you were to invest $1000 and speculate on the Oil market with leverage of 1:20, you would then be able to trade with the weight of $20,000. This multiplies the buying power of an individual investor, allowing them to trade larger volumes than would be possible with their initial investment of $1000. The benefit of using leverage is that if the price of the financial asset, in this case, Oil, rises then your profit is multiplied by 20. Of course, the risk of loss is also equivalently multiplied when trading with leverage.
Leverage is calculated as a ratio, it is the size of the investor’s funds to the size of the broker’s credit. Although the brokerage firm will set a maximum amount of leverage, the investor often has the opportunity to select their own level of leverage. Investors should carefully consider the leverage ratio that suits them best in relation to each individual financial instruments, in order to manage risk accordingly.
Leverage can be used when trading most financial instruments including Forex, Stocks, Cryptocurrency, Commodities, and Indices. The amount of leverage available varies based on the brokerage firm, as well as the financial instrument that is being speculated on. Leverage is a complex trading tool and can be profitable when trading, but the reverse is also true.
In closing, leverage allows traders to speculate on assets with a magnified net result of an investment. This allows investors to amplify their profits, however, it also means their loses will be multiplied, as they are based on the full value of the position.