Understanding Leverage and Margin | eToro

Leverage and margin are features in trading that allow traders to control larger market positions with smaller deposits. Understanding how these processes work, including the risks and costs involved, is essential for anyone considering trading leveraged financial instruments.

Leverage and margin trading is used by those looking to increase the risk-return ratio of their investments. Both processes refer to the ability to open a large trading position with less up-front capital than would be required if buying the asset outright.

Trading using leverage and margin magnifies the size of losses as well as gains, which means it is crucial to develop a clear understanding of what is involved before using them.

What Is Leverage?

Leverage is a trading tool which lets you open positions in financial instruments which are greater in size than the money you have in your account, increasing your potential market exposure. If a trader used leverage of 1:4 they could use a $500 deposit to open trades with a value of $2,000.

Leverage amplifies gains and losses because profit and loss are based on full exposure, not the deposit amount.

Case Study – Leveraged trade in Tesla Motors

1. A trader deposits $500 into their trading account.
2. Using leverage of 1:4 they open a long $2,000 CFD position in Tesla Motors Inc (TSLA) stock.
3. The price of TSLA stock falls by 4%.
4. The trader closes the trade crystallising their loss of $2,000 x -4% = -$80.
5. The traders cash balance is now $420.

Note how the amount of profit/loss on leveraged trades is applied to the total exposure not the initial deposit. The loss is therefore $80 ($2,000 x 4%) not $20 (500 x 4%).

These examples are simplified and for illustrative purposes only; actual liability depends on personal circumstances and local laws.

Leverage is fundamentally a multiplier that determines how much market exposure a trader can access relative to their deposit. These are some of the key characteristics of how it works:

• Leverage is expressed as a ratio. A 1:10 ratio reflects the overall exposure will be x10 the initial deposit.
• The maximum leverage available varies by instrument type and is often subject to regulatory limits. 
• More volatile instruments typically have lower maximum leverage ratios to reflect their higher risk profile. 
• These limits exist to help protect traders from excessive risk exposure but trading with leverage is still considered high risk.
• Leveraged products can produce larger gains or losses compared to unleveraged positions of the same initial investment size.

Traders using leverage can typically set the level of leverage they want to use at the time of opening a trade. Here’s how different leverage ratios affect exposure on the same deposit amount.

What Is Margin?

Margin is the amount of money set aside to open and maintain a leveraged position – it acts as collateral and helps cover potential losses. In the example of a trader using $500 to open a leveraged position of $2,000, the $500 amount is the “margin”.

The key characteristics of margin are:

• Unlike leverage (which is a ratio), margin represents an actual monetary amount.
• The margin requirement is linked to the position size and amount of leverage used.
• The margin you place with the broker is what gives them the confidence to let you trade using leverage as brokers can extract any losses from your capital deposit.

Calculating margin gets more complicated when you also hold assets such as stocks, bonds and forex, and when you have profits or losses on open positions. Your broker might consider those positions as forms of collateral and incorporate them into the formulae they use to determine your overall margin level.

Key margin terminology

Terms which are commonly used when discussing margin and leverage are outlined in the table below. Developing an understanding of them can help traders monitor their account status and risk levels when using leverage.

How Does Leveraged Trading Work?

Leveraged trading uses margin deposits as collateral to allow traders to open positions which have greater market exposure than the size of their initial deposit. The way the process works in practice reflects the differences between trading with leverage and traditional investing.

• Trading gains and losses are calculated on the full position size and applied to the margin amount. 
• The life cycle of profitable trades will be similar whether you are using leverage or not. Profits will be posted to your cash balance when you close the position.
• If losses reduce available margin, a broker may implement a margin callor a stop-out to restore the balance between collateral and exposure levels.
• Overnight financing fees are applied to leveraged positions to reflect a broker is effectively lending capital to a trader to enable them to hold positions greater in size than their deposited cash.
• Trading using leverage and margin magnifies both potential gains and losses.

Leverage, margin, and risk

Brokers don’t want you to hold a position that might end up making a loss greater than the deposited funds you placed with them as they would risk being liable for your losses. 

As a result, traders holding loss-making leveraged positions might be asked by their broker to boost their margin by depositing more funds. If this does not resolve the situation the broker is entitled to close out the trader’s positions to reduce the risk exposure.

Examples of Leverage in Trading

Examples show why leverage changes outcomes: the same price move produces a larger gain or loss when exposure is higher, because P&L is based on the position’s exposure rather than the margin deposit.

Consider a hypothetical scenario where a trader has $1,000 available and is interested in taking a position on a stock currently trading at $50 per share. The following table demonstrates how leverage affects both potential outcomes and how the same 10% price movement produces proportionally larger monetary gains or losses as leverage increases.

These examples are simplified and for illustrative purposes only; actual liability depends on personal circumstances and local laws.

This table clearly shows that with 1:10 leverage, a 10% adverse price movement could potentially deplete the entire $1,000 initial deposit.

What costs can apply to leveraged positions?

Leveraged products can include trading costs (spread) and holding costs (overnight financing). These costs vary by instrument and will affect net outcomes, especially when positions are held for an extended period of time.

Understanding the full cost structure is essential for accurate profit and loss calculations:

These costs are particularly important for leveraged positions because they’re typically calculated on the full exposure amount, not just the margin. 

Final thoughts

Leverage multiplies both gains and losses proportionally to the exposure controlled, making comprehensive risk management essential. That involves understanding margin, costs, and broker risk controls which explain why leveraged products typically carry higher risk than unleveraged positions.

Some brokers provide negative balance protection for certain client classifications; where it applies, it is designed to limit losses to the funds in the account. However, protection levels and availability vary by jurisdiction and client type, so traders should verify what protections apply to their specific situation.

Learn more about CFD trading by joining the eToro Academy.

FAQ

Can I use leverage on short positions?

Yes. You can use leverage on short positions which aim to benefit from the price of a market falling. The mechanics of the trading process are the same as with long positions, but there are additional charges such as stock-loan fees, and specific risks which are even more acute when leverage is applied. Losses on short positions are potentially infinite as upwards price moves in an asset are unlimited.

How can you avoid a margin call?

If you don’t trade CFDs, you will never have a margin call. If you do trade CFDs, bear in mind that even trades without leverage can still trigger a margin call. To reduce the likelihood of receiving one, however, you could design a low-risk investment strategy. Alternatively, you can prepare for market volatility by funding your account with additional cash that can act as a protection buffer against a sudden price change.

What is a stop-out and how is it different from a margin call?

A stop-out is the automatic closure or reduction of positions when account equity falls below a specific threshold. While a margin call is a warning requesting more funds, a stop-out is an automatic action. Stop-out levels and procedures vary by broker and may change in real-time in response to changing levels of market volatility.

Can unleveraged positions involve margin calls?

Margin calls specifically relate to leveraged positions where borrowed exposure exceeds available collateral. Unleveraged positions, for example, purchases of stocks without leverage don’t involve margin calls, though other account management rules may apply depending on the broker and product type.

How do you know if your account is in a margin call?

You can monitor your margin levels by accessing your brokerage account. Your broker will likely message you if your account is approaching a situation in which a margin call might occur. It is important that you don’t ignore these messages and keep up to date with market events which might place stress on your portfolio.