What is leverage in trading?

What is leverage and how does it work?

It is immediately necessary to make a due distinction: with the term "financial leverage" we can refer to an instrument linked to the world of trading, and therefore of pure finance, which it allows to be exposed on the market with more capital than the one actually held, both - in business economics - measure of a company’s debt.

What is leverage in trading?

Leverage is a fundamental tool in trading, since it allows you to expose yourself to the market for a certain amount of money while not having the entire amount in your account. With this tool it is possible to invest an amount that can be N times higher than the actual disbursement of the operator.

Basically, those who use leverage use money loaned from the intermediary (broker or bank) to open one or more positions on the market, against a smaller investment. In this way you can generate greater profits, but consequently also greater losses.

Traders use leverage to amplify their exposure to various markets. This allows them to keep more cash in their portfolio to focus on other investments. You can use leverage on most markets, such as stocks, forex, commodities, indices, bonds, ETPs and certificates.

From a regulatory point of view, the ESMA, European Securities and Markets Authority, on 27 March 2018 imposed new rules regarding the use of financial leverage in online trading, in particular on CFDs. These new measures have been introduced to safeguard retail operators from incurring excessive losses.

Leverage: an example

Through financial leverage, for example, you can invest even just 100 euros, but open a position that is also worth more than 1,000. The difference is made by the intermediary (broker or bank).

Any profit deriving from the operation, as well as any loss, is calculated on the countervalue handled, i.e. 1,000 euros.

It can therefore be understood that through financial leverage, the profit that can be recorded in a specific sale and purchase transaction is far higher than the profit that can be recorded with only 100 euros of initial investment.

The use of financial leverage is granted by intermediaries (brokers or banks) against a guarantee margin of the position in your account, calculated as a percentage of the value of the open position.

From a mathematical point of view, leverage can be expressed with the following formula:

Leverage= Invested Capital/Equity

All that remains is to understand what the Margin is and its close relationship with the Financial Leverage.

Leverage and margin: the difference

To allow less capitalized operators to use financial leverage, intermediaries offer the possibility of operating "on margin", i.e. they set a percentage of the countervalue of the transaction which will be withheld from the trading account and, if necessary or requested by the intermediary, supplemented or reduced according to needs.

The margin is therefore a collateral guarantee that the operator delivers to the broker in order to take advantage of the loan of the additional capital necessary to open a transaction. Once the position is closed the margin is replenished, i.e. returned. Therefore the margin does not express a cost for the trader.

The margin required to use leverage varies from intermediary to intermediary, from underlying to underlying. It is therefore strongly recommended, before undertaking any operation, to find out about the policy of your intermediary on the use of leverage.

It is important to keep in mind that Leverage and margin are inversely related: the higher the leverage, the lower the margin required by the intermediary.

Margin = 100/ Leverage

An example will more easily clarify what has been argued so far. Assuming you open a trading account and deposit 1,000 Euros, in the case of Leverage equal to 20 (1:20), the margin required by the broker will be 5%, while the maximum value of the The transaction is equal to 20,000 Euro.

If the direction assumed during the transaction analysis phase turns out to be correct, there is no problem. But if the desired direction finally turns out to be wrong, you could run into a Margin Call: the broker will liquidate the position to try to ensure that you do not lose more money than what is available in your account.

Finally, each intermediary defines the financial leverage allowed on the basis of the legal limits established by the institution that regulates the markets and financial instruments at European level, i.e. the ESMA (European Securities and Markets Authority).

Original article published on Money.it Italy 2023-04-19 17:04:50. Original title: Cos’è la leva finanziaria?