Many cliches are used to describe the concept of leverage as it relates to active trading. "Double-edged sword" or "two-way street" are a few of the most common ways of verbalising the meaning of leverage, or more importantly, its impact upon a trading or investment account.
Leverage is the ability to control a large quantity of an asset with a relatively small initial capital outlay.
A real-world example of financial leverage is the purchase of a home using a fractional downpayment and a larger financed balance. While the homebuyer is technically bound by the eventual payoff of the mortgage, only a much smaller down payment is required to secure the deal.
As a result, the new homeowner has taken a long position in the local real estate market, effectively controlling an asset that is worth much more than the initial cash investment.
Effective leverage is the amount of equity being used in relation to the aggregate value of an open position. Using the home purchase example, assuming a 20% down payment and a £330,000 sale price, effective leverage is calculated as follows:
Effective Leverage = Total Position Size / Account Equity
- Effective Leverage = (£330,000/(.20 * £330,000)) = 5
The effective leverage of the home purchase is an illustration of the amount of equity used to control the value of the entire investment, in this case a ratio of 5:1.
The active trade of currencies, futures or equities function in a similar manner to a home purchase. However, the use of liquid cash as the primary means of settlement emphasizes the concept of effective leverage. As an illustration of its impact upon a forex trade, take the following scenarios:
- Trader A has an account balance of £10,000 and decides to short 20 standard lots of the EUR/USD:
- Effective leverage= (20 * £100,000)/£10,000 = 200:1
- Trader B decides to short 20 mini lots of EUR/USD, using the same £10,000 account balance:
- Effective leverage= (20 * £10,000)/£10,000 = 20:1
The effective leverage of Trader A's account is 200:1, while Trader B's is 20:1. The difference in leverage greatly increases the value of each pip, which in-turn magnifies the impact of short-term volatility. While Trader A stands to realise a profit 10 times greater than Trader B from a positive move, a negative move is detrimental 10 fold.
Fortunately, there are constraints placed on position sizing and the degree by which leverage may be implemented in the markets of futures, currencies and equities. Margin and maximum leverage requirements address the terms by which traders and investors are able to access credit within the marketplace:
- Margin: Margin trading takes place when a buyer or seller places a percentage of an underlying asset's value down and borrows the balance from a broker. For instance, if an energy futures trader is interested in purchasing 1 contract of WTI crude oil (1,000 barrels) at a price of £50 per barrel, the contract is worth £50,000. In order to facilitate the trade, a broker will require a specified percentage of the contract's value to remain in the client's trading account. The balance insures the broker from taking a loss on the trade, placing the financial responsibility of the open position solely on the trader.
- Maximum leverage: Maximum leverage is the largest customer position size allowable. For instance, in forex, common maximum leverage ratios range from 100:1 to 200:1. It is up to the individual to learn what the maximum leverage constraints are and how they will be applied to the trading account.
While it's true that leverage is a necessary component for the facilitation of trade, understanding how it works and its impact upon risk capital is an essential part of interacting within the marketplace. The inability to balance risk with reward, or to properly implement leverage can pose a challenge individual's longevity within the marketplace.
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