Financial Leverage
Leverage is a tool offered in Forex and CFD investments, which allows to multiply the performance of the asset in which we have invested.
Created as a tool for Forex trading, nowadays it is available on all CFDs, ETFs and other types of derivative instruments, Futures and options. Financial Leverage can be a useful tool to increase the volatility and price movement of financial security or to be able to expose ourselves to positions much larger than the capital we can commit.
Although many consider it to be a shortcut to greater gains in online trading, leverage is a double-edged sword that must be handled with extreme care by the investor.
As far as the European continent is concerned, the maximum leverage that can be applied to each asset class is set by ESMA, which has intervened repeatedly in recent years to limit the margin provided by this tool, at least for non-professional clients.
Financial leverage – Main features:
| ❓Why it is used: | Multiplying fluctuations, heding, trading on margin |
| 🤔Assets: | Forex, stocks, ETFs, derivative contracts, commodities, cryptos, indeces |
| 💰Costs: | Overnight fees depending on the interest rate |
| ⛔Risk | High |
| 👍Where can you use it: | Best online trading platforms that allow trading on margin |
What is financial leverage: definition
Financial leverage is technically a loan from the broker, which allows us to make larger investments than we could make using only our capital. Our capital will be used as collateral. If the loss of the total capital we have invested exceeds our collateral, the position will be closed automatically. If we make a profit, it will be calculated on the total amount we have invested (guarantee and borrowed capital).
Let’s see how this mechanism works:
- Technically it is a loan
Whenever we open a leveraged position, we are in effect getting a loan from our broker, who usually relies on external liquidity providers to ensure that all his clients never run out of money to borrow.
If we buy with 1:5 leverage 1,000 euros of Apple shares, we will be exposed for 5,000 euros in the market, automatically borrowed by the broker (and its liquidity providers). The 1,000 euros we have committed will be used to hedge against changes in the price of the stock.
If we buy with 1:5 leverage 1,000 euros of Apple shares, we will be exposed for 5,000 euros in the market, automatically borrowed from the broker (and its liquidity providers). The 1,000 euros we have committed will be used to hedge against changes in the price of the stock.
- Multiply profits and losses
Depending on the leverage we are going to use, this tool will multiply the performance of the stock we have chosen. Let’s take the example of an investment in stocks, on which we have chosen to apply a leverage of 1:2.
Our capital will have to cover 50% of the total investment and if the stock rises by 5%, we will obtain a total gain of 10%, that is 5% x 2. However, the trend is multiplied even in case of loss. If the security we have chosen and on which we have invested with 1:2 leverage were to lose 5%, we would find ourselves with a net -10% in capital, for the same principle as above.
- Legal restrictions apply
There are different laws around the world regarding leverage. Within the European Union, for example, the relevant financial authority is ESMA. ESMA has limited by law the leverage that brokers can offer to non-professional clients, so for example on stocks you usually get a leverage of 1:5.
In the U.S., the Commodity Futures Commission has imposed a maximum leverage of 1:50. This level of leverage can only be offered on the most liquid Forex pairs, while for the rest of the Forex pairs it drops to 1:20 and the value drops further for instruments such as stocks and ETFs.
In the UK the maximum leverage is limited by the Financial Conduct Authority to 1:30; in Australia ASIC has recently limited leverage to 1:20 and each nation has its own rules on this. However, there are jurisdictions that offer very generous rules, especially in Pacific atolls and exotic nations, where leverage easily reaches as high as 1:200 or 1:500.
- Hedging tool
Leverage is often used for hedging positions, that is, making investments that hedge the risk of others. It is in this case a tool for complex strategies and, at least among professional investors, it is the most frequent reason why leverage is used.
Financial leverage: how exactly does it work?
Leverage has practical applications that today can only interest small and medium investors: it is no longer a tool reserved for complicated inter-bank operations but a possibility offered by a large number of brokers and intermediaries even in retail investment accounts.
- How leverage works in Forex
The currency market lends itself because on the one hand it is relatively stable, and on the other hand because it is a necessary market for many to hedge against the foreign exchange risk of other types of investments denominated in foreign currencies.
In most jurisdictions, Forex enjoys higher limits on leverage because it is believed that this market is less risky than others. Applying leverage to any Forex order will result in a net multiplication of the performance of our investment.
Therefore, leverage in Forex can be used for those who are looking for higher returns while exposing themselves to higher risks. Alternatively,financial leverage in the currency market can be used for hedging purposes, for example, to cover the risk of buying a package of shares in an exotic currency.
- Financial leverage in CFDs
CFDs are derivative instruments that allow you to invest in different types of underlying assets, from commodities to stocks, passing also through ETFs, bonds, stock market indices and cryptocurrencies. This type of contracts can integrate a financial leverage that can be chosen by the investor at the time of opening the trade when placing the order.
The principle of operation is the same as we have seen in Forex. In fact, we can choose any leverage point – within the maximum set by law – and multiply the performance of the underlying asset we have chosen. Contrary to what happens with ETFs, with CFDs we can choose how much leverage to apply to a single investment.
The reasons for hedging can also be valid in this case, choosing for example a notoriously anti-cyclical asset like gold. Being able to have leverage helps to expose yourself for larger positions than you can actually support with your capital.
- Leverage in ETFs
ETFs, increasingly popular instruments, often already incorporate financial leverage. In this case, the result is obtained thanks to complicated synthetic replication schemes, with the result of being able to offer those who want products that already have a prefixed leverage.
Therefore, it is not uncommon to find securities on the market that already incorporate financial leverage at 2, 3, 5 or 7 on assets that replicate the performance of oil, or natural gas or other commodities.
- The cost of leverage
Financial leverage is technically a loan and therefore has its own interest costs, which should be carefully considered before setting an order. In fact, for both Forex and CFDs there are so-called overnight commissions, i.e. daily commissions in the form of interest that are charged at the end of each trading day.
We have to remember that these commissions, which are always due when trading with this kind of instruments, are calculated having as “taxable base” the whole position, i.e. the whole exposure after the application of leverage.
If we invest on EUR/USD with a leverage of 1:30 1.000 euro, we would be exposed for 30.000 euros in total. The overnight fee should be calculated directly on the 30,000 euro exposure. The differences in cost compared to an investment without leverage should be considered. The best day trading brokers offer a preview of this cost already in the order phase, allowing us to better assess the impact of commissions.
- The risks of leverage
Financial Leverage, as a multiplier of the positions we have in the market, amplifies the risk. Each loss will correspond to a loss multiplied by the level of leverage that we have chosen.
To a greater potential gain always corresponds a greater exposure and therefore a greater risk of losing money. For this reason, we must, before exposing ourselves to this instrument, evaluate the risk we are willing to run in the hunt for a certain level of profit.
Leveraged Investment Examples
We will now do two different examples of leveraged investing, one on Amazon shares and one on gold, using two of the different brokers.
Leveraged investing in Amazon shares with eToro
- First step: get a demo account with eToro
To test our first order we will need a free eToro demo account, an account that provides 100,000 USD of virtual capital that we can freely use for this purpose. After signing up, we can move on to the next point.
- Second step: login to the eToro platform
The second step is just as simple. Using the credentials we chose during the registration phase, we will be able to make our entry into the proprietary trading platform that is offered by eToro.
- Step three: we locate Amazon shares
Amazon shares are listed at NASDAQ and we will be able to find them on eToro via two channels. We can use the search that is positioned at the top of the interface, or follow the path Markets>Stock>NASDAQ>AMZN. In any case, once we have located the relevant stocks on the screen, we can click on TRADE NOW to place our leveraged order.
- Step four: enter the Amazon stock order with leverage
From the screen you see further down you can enter the volume of money or number of Amazon shares to buy, any stop losses and take profits and then set the leverage. eToro allows you to choose between x1 leverage (no leverage), x2 leverage and x5 leverage on stocks in general. We choose the one that best matches our investment strategies and move to an Open position to start the order, which will be immediate.
Note that this broker reports the cost of overnight commissions resulting from the use of leverage, i.e. interest on borrowed money. However, the costs are very small: on a 4,540 USD position in x5 leverage, we are paying 4 USD per day, less than 0.001% of the invested capital.
Buy GOLD on Capital.com with leverage
Capital.com has another way of approaching the issue of leverage and does so by automatically inserting the maximum possible leverage on each order, with the maximum that can be contained by going to modify the platform settings.
- First step: sign up for a demo account with Capital.com
Here we can open the demo account with Capital.com, which allows us to get 1,000 USD test capital to invest in any type of market that is offered by this broker. Once we enter our email and chosen password, we will be diverted directly inside the investment platform of this broker.
- Second step: finding gold on the platform
We can find gold on the platform offered by Capital.com by going to the menu on the left, choosing “Commodities“. Just click on it and then choose GOLD. Let’s click BUY to proceed.
- Third step: place the order
After we have chosen gold, on the right column we can insert our order measured in ounces. Under the quantity we will also find the indication of the margin, i.e. the amount of money we are going to commit to go and buy the certain amount of gold we have indicated.
The functioning of this broker is very particular in this sense because it is not possible to modify the maximum leverage applied during the order phase. To do so, we will have to go to Settings > Trading Options and then change the leverage applied from the screen that we have shown below. The change can also be done on an order by order basis. Once we deem the appropriate leverage and other details of our order correct, we can move on to the order by clicking BUY.
Best trading platforms with financial levarage [TOP LIST 2021]
67% of retail CFD accounts lose money.
67,7% of retail CFD accounts lose money.
48% of retail CFD accounts lose money.
79,90% of retail CFD accounts lose money.
All the best European Forex and CFD brokers offer leverage within, in trading platforms jurisdictions where it is allowed by law. Let’s also see what their main features are outside of leverage.
It is one of the most popular brokers in the world and allows you to go and invest in over 2,100 securities, spread across stocks, Forex, commodities, cryptocurrencies, ETFs and indices. It offers a CFD mode for all leveraged investments, while also offering a DMA (Direct Market Access) mode on Stocks, ETFs and Cryptocurrencies when you choose to trade without leverage.
In relation to what is offered by this broker in terms of leverage, we should definitely highlight also the possibility to invest by spending very small amounts in terms of overnight commissions. The commissions and operations of eToro can also be checked with its free practice account, which allows you to invest freely under the same conditions as real accounts.
In relation to what is offered by this broker in terms of leverage, we should definitely highlight also the possibility to invest by spending very small amounts in terms of overnight commissions. The commissions and operations of eToro can also be checked with its free practice account, which allows you to invest freely under the same conditions as real accounts.
Capital.com is a Forex and CFD broker that applies maximum leverage limits on all the products it has listed. In Capital.com’s free demo account it is also possible to trade with higher levers, which are those guaranteed to those who log in as professional investors.
10,000 USD (renewable) of virtual capital, proprietary platform and access to over 3,000 securities complete the picture of a valid broker that has many satisfied clients in Europe, as evidenced by the reviews of both our staff and the most reliable third-party sites.
FP Markets is a multi-asset broker that operates with different levels of leverage in the various countries in which it operates. The service is particularly focused on offering Forex pairs, American, Australian and Hong Kong stocks, with a minimal selection of securities from other markets as well.
Highly professional broker, offering both MetaTrader for its CFD section and IRESS for its DMA pricing mode, to reduce spreads to the very core. You can test the demo account here with 100,000 USD of virtual capital.
Trade.com is a multi-asset broker with over 2,300 securities listed, which also allows access to leverage in all the jurisdictions in which it is present. To trade with Trade.com you can choose between MetaTrader and the proprietary web platform, without any kind of restriction on the level of leverage you can apply. You can test on the demo account here free of charge and above all with commissions and leverage that are identical to those that we can then use during the trading phases with real capital.
Characteristics of financial leverage
Financial Leverage is a way of investment where the bettor has to cover only the “margin of movement” of the price and not the entire position. It is a way of operating typical of derivative contracts, which leads to advantages that we have already partially explored and that at least in the applications of the best brokers, has really interesting features.
- Modularity
The real revolution of online trading platforms, especially those that operate with CFDs, has been to leave carte blanche to the investor to apply the leverage he prefers. This translates into greater flexibility in investments, better adapting to the risk profile of each investor.
- Short term amplification
One of the most frequent problems for those who want to invest in the financial markets is not having enough volatility on the markets to do very short term trading. In this sense leverage can be of great help to those who want to invest in scalping or intraday mode. A variation of 0.5% on the value of an action, for example, becomes a variation of 10% on the capital we have invested if we have decided to use a leverage of 1:20.
- Risk management tool for hedging
Risk management is very important for those who want to create portfolios and investment strategies. The fact that leverage can be used as a cheap hedging tool makes it very convenient for those who want to hedge against risk. Once upon a time, only the big hedge funds thought in these terms, but now virtually anyone could manage to hedge against currency risk using CFDs and leverage.
- Simple to use
Platforms have made great strides in the last few years and today they make it very easy to apply leverage to any type of order. Even a novice user can usually figure out how and where to intervene in the interface to make the desired trade.
In most cases, it all comes to to clicking “2x” or “5x” or any other amount of leverage that you want to use. Most platforms also allow you to know in advance how much interest you will owe on the borrowed capital when you open your trade.
Financial Leverage: Formula
The leverage formula is the simplest we can find to calculate within the world of finance.
Typically it is expressed either in the form of 1:x (where 1 represents the capital used as collateral and X for the total capital actually invested) or in the form of x2-x3-etc. or in the form of a multiplier. Nothing changes for calculation purposes, because we will have to multiply:
- Capital committed to the position x with applied financial leverage
And therefore multiply, in the case of a 1.000 euro position with 1:10 leverage, 1.000 by 10, obtaining 10.000 euro which will be the effective exposure on the markets.
If we have a broker that gives us leverage in the form of a multiplier, as in the case of x3, X4 and so on, we can do the exact same calculation. On a position of 1,000 euros in x10 leverage, we will have to multiply 1,000 x 10 to get the actual exposure of 10,000 euros.
Financial leverage calculation: a few examples
The calculation of leverage is not complex. Let’s imagine that we have invested in Apple shares with a leverage of 1:5, i.e. a leverage multiplier of 5. Let’s also imagine that we have invested 1,000 USD in this position.
- In the case of a 2% increase in the value of Apple shares
We will have to multiply 2% by the value of leverage and we will get 10%. We will have earned 10% of the capital actually committed, i.e. 1,000 USD and therefore we will have earned 100 USD, against an actual movement of the stock of only 2%.
- In the case of a 3% decrease in the value of Apple stock
We will have to multiply the leverage x5 by the percentage value of variation, that is 3%. We will have 15% in total, which will have to be subtracted from the capital actually invested, and therefore -15% of 1,000 USD. We will therefore have lost 150 USD of our investment.
Forex financial leverage
Financial leverage is a structural part of Forex, both because it allows multiplying the typically small fluctuations of this market and because hedging strategies are often used to hedge currency risk.
Although leverage is regulated differently by individual nations’ regulations, normally Forex is the market where brokers are allowed to offer the highest leverage. This ranges from 1:30, as in Europe, up to even 1:500 as offered by many FSCA regulated brokers in South Africa.
Leverage is essential in the world of Forex because currencies have very small fluctuations on a day to day basis. If their trend were not multiplied by leverage, it would be virtually impossible to get interesting returns from this market.
Leverage within the Forex market can be, as well as in other markets, applied to short positions: in this case, the operation is absolutely specular – because there will be an amplified gain in case of a fall in the exchange rate and there will be a loss in case of an increase.
Leverage also has the great merit of being able to offer an immediate increase in volatility even for pairs that travel on particularly stable prices, thus allowing even those who invest in the short and very short term to get enough movement to trade.
As far as the link between hedging and leverage is concerned, thanks to this instrument we can protect ourselves, for example, from the exchange rate risk we would have to bear by investing in assets denominated in currencies other than the one we normally use. This is the typical example of investments to hedge positions in commodities, ETFs, bonds and equities listed on emerging markets.
Banks and financial leverage: what to know
When we talk about leverage in the banking sector, we are actually in a very different field from the one we have dealt with so far. The leverage ratio of banking institutions is in fact the ratio between the institution’s net capital instead of the total assets.
It is a good indicator of the risk profile faced by a banking institution. If a bank has a leverage ratio of 1:10, for example, it means that for every $10 deposited by its depositors, the bank uses $9 to finance mortgages, loans and other operations. The more liquidity the bank can invest, the more interest it can generate; on the other hand, this also means that the bank is more exposed to the risk of non-performing loans and recessions.
To prevent banks from risking too much of their customers’ money, most countries have laws on the maximum leverage of banking institutions. Especially after the sub-prime mortgage crisis in 2008, these limits were tightened, in order to prevent a new crisis due to non-performing loans.
Financial leverage: Opinions and Reviews
Leverage is a very popular tool today, thanks to the huge expansion of CFD brokers within the retail investment market. However, the fact that it is so widely available should not necessarily be an invitation to use it in every case and under all circumstances.
Therefore, we are going to list our opinions and reviews on leverage, matured during years of trading and after more than 10 years as financial popularizers, in order to go beyond the purely academic approach and enter the real case scenario.
Is it worth using it? ADVANTAGES and DISADVANTAGES
In the world of investments, we can never speak correctly about tools and products that are convenient for everyone and we cannot do so even with leverage, an instrument that has its own particularities and that surely, due to its very way of working, is not suitable for everyone.
By analyzing the pros and cons of this instrument, we will be able to realize in a more transparent and intelligent way what the advantages may be for our trading style, for our risk profile and more generally for our investment strategies.
FINANCIAL LEVERAGE – ADVANTAGES
- Increased volatility of the underlying asset
This is a pro, if you will, relative only to those who need markets and assets that move quickly enough to allow short and very short term investments. Maximum leverage can certainly move markets that would otherwise be almost immobile and open up greater opportunities for scalping or intraday trading.
Take the Forex market as an example. Currencies barely move every day, with changes in the order of just a few pips on some occasions. Even with a very good strategy, it would be hard to profit more than 3-4% a year on a solid trade. By multiplying this percentage with leverage, however, also the Forex market can be traded profitably.
- Hedging of inverse correlation positions
Hedging the risk of other positions is very useful when exposing yourself to volatile markets. For example, if you have invested in the electric car market, you could lose money if the price of lithium rises so much that these cars become unattractive. In order to hedge yourself, you could invest, using leverage, in the major companies that sell lithium and would benefit from high prices. This advantage in hedging remains – at least for our editorial staff – one of the most attractive features of leverage and margin investing.
- Multiply earnings
The good side of the leverage coin: obviously, when you have a winning position, when you have guessed a strategy, leverage works directly as an earnings multiplier. As we will see in a moment, there is also another side of the coin that we must necessarily consider when approaching this type of instrument.
This also applies to other streams of income derived from trading securities, not just the capital gain. If we purchase more stocks or more bonds by applying leverage, we also get more dividends or interests
FINANCIAL LEVERAGE – DISADVANTAGES
Obviously, the disadvantages of this tool must also be considered, which sometimes make leverage unprofitable for those who want to invest.
- Costs
The increase in leverage increases the costs that are linked to any type of trading operation. This is because the spread and overnight commissions are calculated on the entire position, including the leverage multiplier and not just on the actual capital employed.
Although the best brokers operate with overnight commissions and spreads that are very low, the fact remains that we are faced with a real problem that must be calculated before opening positions. The most advanced brokers allow you to calculate, at the opening of the position itself, the value of those commissions.
- Increased risk
This is the other side of the coin of increasing eventual profits. When we use leverage, it operates as a multiplier not only on profitable positions but also on positions that have made losses.
If leverage is then applied to positions that are already risky – on assets that are already particularly volatile – the risk very often exceeds the threshold of tolerability even for those who have a very strong propensity for leverage.
Our opinion on the use of financial leverage
Financial leverage is a useful and powerful tool that can always be considered for setting an order within a complex strategy.
However, we must be careful to consider leverage as a valid solution for any type of portfolio and investment strategy.
Financial leverage must always be handled with extreme care, taking into account what may be the risks related to exposures that are amplified through this precise instrument. We must also discard, at least in our opinion, the opinions of those who urge us to always invest with the maximum leverage allowed.
We would like to reiterate, at the end of our opinions, that leverage must be considered for what it is: a very powerful tool that therefore must be handled with extreme care, precisely because in the world of finance, great possibilities always correspond unequivocally to equally important risks.
The same opinion seems to be shared by most of financial authorities around the world; we have seen many of them imposing limits on the amount of leverage that investors can use, but none of them has banned it completely. Just as any other financial tool, it should be used in the appropriate occasions and “black or white” opinions should be avoided.
Financial leverage in business economics
In business economics, leverage is the ratio of debt to equity of a company.
A higher ratio corresponds to a higher level of risk that the company may not be able to repay its debts and therefore go bankrupt. This is not the only tool for assessing the actual health of a company, but very often when the leverage of a company is very high, bankruptcy is just around the corner.
According to the prevailing doctrine in business economics, a leverage ratio for companies between 1 and 2 would be the correct one. If the ratio is higher than 2, the company is considered undercapitalized.
The most widely used formula for calculating this specific magnitude is as follows:
- (Equity + debt capital) / debt capital
If a company had equity of 20 million Euros and a debt capital of 10 million Euros, the leverage ratio would be 30/20, or 1.5, indicating a good state of health of the company.
Keep in mind that every company should be analyzed differently depending on the sector in which it operates and the stage of the company life cycle. Startups tend to have higher debt-to-assets ratios, while established company are usually less in debt.
Financial Leverage risks
We have already mentioned in several sections of this guide the risks that are inherent in leverage and its application. The principle should be clear by now to those who have followed the guide up to this point, and we will go on to set out some operational concepts before moving on to the final conclusions.
- Leverage acts as a multiplier in every case
Leverage acts as a direct multiplier of the performance of a particular security in case of profits and losses. This means that when the underlying asset that we follow with our investment should report a -3%, with a leverage of 1:10 we would record in the portfolio a dry -30% in relation to the capital that we have actually committed.
You should factor the average volatility of a financial asset when you choose the amount of leverage that you want to use on your positions.
- The risk of miscalculation
Operating with leverage requires us to calculate the possible evolutions of our investment. Mistakes, especially for beginners, are frequent and can cause unpleasant surprises.
Leverage certainly increases the complexity of the prior calculation of the possible results of our investment, which remains for us a component of risk. Experience in this sense can offer a hand: learning to use leverage with a free demo account like this one which allows you to gain experience without the risk of losing real capital.
- The risk of commissions
Commissions must always be associated with inevitable losses when trading. Let’s imagine having a portfolio which after 1 year has totalled 0%, i.e. a portfolio which has recovered the losses it has recorded in the first part of the year.
In this case, we would be almost at breakeven if we had not used any kind of leverage. With leverage instead, especially on positions held for a long time, we will have a loss equal to the rate charged by our broker on the capital we have borrowed. This is equivalent, albeit indirectly, to greater risks that can be considered as part of the leverage and that must be, at least in our opinion, definitely calculated.
Final Considerations
Leverage is a very useful tool and part of the goodness of the offer from CFD brokers. However, like all investment tools, it should be known, evaluated and used only when needed.
Our opinion is that financial leverage is a very useful tool when used in the right way. We believe that it is important to know its mechanisms and learn to understand when and how to use them.
Often those who use very high levels of leverage are incurable optimists about their investments. It’s right to be optimistic, but keeping in mind that that being always profitable doesn’t succeed even for legends like Warren Buffett. Therefore we can only make up our readers from this insight and evaluate for themselves if and when to apply leverage to their investments.
FAQs about Investing with Leverage
What is leverage?
Leverage allows investors to borrow money from their broker, in order to open larger trades while also multiplying the effect of price changes.
Is leverage risky?
Yes. Leverage enhances risks for investors.
What can I trade using leverage?
Leverage can be used to trades Forex, stocks, commodities, ETFs, cryptos and related derivative contracts, such as CFDs and futures.
What are the costs of leverage?
Since leverage implies borrowing money from the broker, the trader owes interests that are charged everyday (usually at 11 pm) on the borrowed capital.
Do ETFs use leverage?
Some ETFs are leveraged, but most of them are not.
