Understanding leverage and margin

Leverage is the ability to take a position whose total value is several times larger than the capital deposited to open it. Instead of paying the full notional value of a trade, the trader puts down a small percentage as a deposit, with the broker effectively financing the rest.

Leverage is expressed as a ratio. A leverage of 1:100 means that for every $1 of margin deposited, the trader can open a position worth $100. A leverage of 1:1000 means $1 of margin opens a $1,000 position. Higher leverage allows larger positions to be taken for the same deposit, but it does not reduce the risk of those positions.

Margin is the portion of an account's balance that the broker requires the trader to set aside as a deposit against an open position. It is sometimes described as a good-faith deposit.

Required margin is calculated as the position's notional value divided by the leverage ratio. A position with a notional value of $100,000 opened at 1:100 leverage requires $1,000 of margin. The same position opened at 1:1000 leverage requires $100 of margin.

Margin is not a fee. It remains in the trader's account but is locked while the position is open. If the trade is closed at a profit, the margin is released along with the profit. If the trade is closed at a loss, the loss is deducted before the remaining margin is returned.

Suppose a trader wants to open a position of one standard lot on EUR/USD. One standard lot represents 100,000 units of the base currency, so the notional value of the position is approximately $108,500 at a price of 1.0850.

At 1:100 leverage, the required margin is $1,085. At 1:500 leverage, it is $217. At 1:1000 leverage, it is $108.50.

In each case, the position itself is the same size. A 50-pip move in the trader's favour produces approximately $500 of profit. A 50-pip move against produces approximately $500 of loss. The leverage ratio does not change the size of the price move, the size of the position, or the profit and loss outcomes. It only changes how much capital is required to open the position in the first place.

When a position moves against a trader, the loss reduces the equity in their account. Brokers monitor the relationship between equity and the margin required to maintain open positions, known as the margin level.

If the margin level falls below a defined threshold, the broker issues a margin call. This is a warning that the account is close to having insufficient equity to support its open positions. If the margin level falls further, the broker triggers a stop-out, automatically closing positions to prevent the account from going into a negative balance.

Stop-out levels vary between brokers. The mechanism exists to protect the broker and, in many jurisdictions, the client, but it does not guarantee that losses will be limited to the deposit.

Leverage is the feature of CFD trading that allows small price movements to produce significant outcomes relative to the capital deposited. A 1% move on a $100,000 position is $1,000. If that position was opened with $100 of margin at 1:1000 leverage, a 1% move against the trader represents ten times their initial deposit.

This is why CFDs are categorised as complex financial instruments. The proportional impact of price movement on deposited capital is unlike most other forms of retail trading. Leverage should be sized to risk tolerance, not to the maximum the broker offers.