Leverage is the investment strategy of using borrowed money: specifically, the use of various financial instruments or borrowed capital to increase the potential return of an investment. Leverage can also refer to the amount of debt used to finance assets. When one refers to something (a company, a property or an investment) as “highly leveraged,” it means that item has more debt than equity.
Leverage Ratio and Minimum Margin Requirements
Leverage is expressed as a ratio and is based on the margin requirements imposed by your broker.
For example, if your broker requires you to maintain a minimum 2% margin in your account, this means that you must have at least 2% of the total value of an intended trade available as cash in your account, before you can proceed with the order.
Expressed as a ratio, 2% margin is equivalent to a 50:1 leverage ratio (1 divided by 50 = 0.02 or 2%). The following table shows the relationship between leverages and minimum margin requirements:
Comparison of leverage ratios and the minimum margin requirements expressed as a percentage.
requirements expressed as a percentage.
If Leverage Ratio is…
Then, the Minimum Required Margin equals…
As a trader, it is important to understand both the benefits, and the pitfalls, of trading with leverage.
Using a ratio of 50:1 as an example, means that it is possible to enter into a trade for up to 50 dollars for every dollar in the account.
This is where margin-based trading can be a powerful tool – with as little as $1,000 of margin available in your account, you can trade up to $50,000 at 50:1 leverage.
This means that while only committing $1,000 to the trade, you have the potential to earn profits on the equivalent of a $50,000 trade.
Of course, in addition to the earning potential of $50,000, you also face the risk of losing funds based on a $50,000 trade, and these losses can add up very quickly.
Traders suffering a loss without sufficient margin remaining in their account run the risk of triggering a margin closeout.