What does leverage mean? The trading secret of using small amounts of money to control large funds

You may have heard many people talk about the word “leverage” in the stock or forex markets, but what does leverage actually mean? Simply put, leverage is using borrowed money to amplify your trading size, allowing you to control a larger investment position with less of your own capital. It’s like using a lever to move a big stone—you exert less effort, but can move something much larger.

Understanding the Basics of Leverage: Margin and Leverage Ratio

Imagine you have $1,000 but want to trade $100,000 in the forex market. What if you don’t have enough cash? That’s where leverage comes in.

Your broker will require you to put up a portion of your funds as “margin,” which is the minimum balance your account must maintain. Once you deposit the margin, the broker loans you the remaining amount, enabling you to trade on a larger scale.

Leverage multiples are usually expressed as ratios, like 1:100, 1:200, etc. This ratio indicates how much of your own money you need to control a larger position. For example:

• Leverage 1:100: You put in $1, control $100 worth of trades. The required margin is 1% of the trade size.
• Leverage 1:50: You put in $1, control $50 worth of trades. Margin needed is 2%.
• Leverage 1:200: You put in $1, control $200 worth of trades. Margin needed is 0.5%.
• Leverage 1:500: You put in $1, control $500 worth of trades. Margin needed is 0.2%.

Different brokers offer different leverage options, typically ranging from 1:1 to 1:500. The higher the leverage, the lower the margin requirement.

How to Use Leverage? Three Real-World Scenarios

Let’s look at three specific trading scenarios to understand how leverage works in practice:

Scenario 1: Conservative Trading - Leverage 1:100
Suppose you want to trade a $100,000 position, and the broker requires 1% margin, which is $1,000. That means with just $1,000 in your account, you can trade $100,000.

Scenario 2: Moderate Risk - Leverage 1:50
For the same $100,000 position, using 1:50 leverage, the broker requires 2% margin, which is $2,000. You have more of your own funds at risk, so the risk is slightly lower.

Scenario 3: Aggressive Trading - Leverage 1:200
Again, trading $100,000, but with 1:200 leverage, the margin needed is only 0.5%, or $500. The least of your own funds is needed to control the largest position.

The Real Impact of Leverage: Doubling Returns and Risks

Now, let’s see how leverage affects actual trading outcomes. Suppose you’re trading EUR/USD at a current price of 1.26837.

You plan to trade 1 lot (which equals $100,000), meaning the trade value is 1.26837 × 100,000 = $126,837.

See the difference? With 1:200 leverage, you only need to put up $634.19 instead of the full $126,837. That’s the power of leverage—trading larger positions with less capital.

But this advantage comes with a cost. Suppose EUR/USD rises by 3 pips, from 1.26837 to 1.26867:

At first glance, both scenarios yield a profit of $130. But what about the percentage return?

• Without leverage: 130 ÷ 126,837 ≈ 0.1%
• With 1:200 leverage: 130 ÷ 634.19 ≈ 20.5%

The same $130 profit translates into a 20.5% return with leverage, compared to just 0.1% without.

Now, if the price drops by 3 pips, from 1.26837 to 1.26807:

Same loss amount, but the percentage loss:

• Without leverage: 130 ÷ 126,837 ≈ 0.1%
• With 1:200 leverage: 130 ÷ 634.19 ≈ 20.5%

This illustrates why leverage is often called a “double-edged sword.” It can magnify your profits, but equally, it can amplify your losses. A small 0.1% market move can result in a 20% loss if you’re using high leverage.

What Does Leverage Mean? Key Takeaways

To truly understand what leverage is, keep these points in mind:

• Leverage is borrowing: It’s a tool to amplify your trading size by using broker’s funds.
• Margin is the foundation: You pay the margin, and the broker lends you the rest.
• Leverage ratios vary: From 1:1 (no leverage) up to 1:500, with higher ratios meaning higher risk.
• Profits and losses are magnified: Leverage doesn’t discriminate between gains and losses; it amplifies both.
• High risk, high reward: Using less capital to control larger positions sounds attractive, but misjudgments can lead to significant losses.
• Risk management is essential: Always set stop-loss orders and never let losses grow uncontrollably when trading with leverage.

Leverage is a powerful tool, but it requires careful handling. Before chasing high returns with leverage, fully understand the risks involved.