One of the benefits of online trading is that you can use leverage.  Leverage is the process of using borrowed capital to enhance your returns. Many brokers will offer leverage using a margin account. This type of account allows you to use the capital in your account and the forex and CFDs in your account as collateral. Your broker will offer different levels of margin depending on the product you are trading. Generally, the higher the volatility of the product, the lower the available leverage. The benefits of leverage come at a double-edged sword. The returns that you can produce are a multiple of what you would experience without leverage. The downside is that your losses will also be accentuated.

What is Leverage and How Does it Work

Leverage occurs when you can use borrowed money from your broker to expand the size of the positions you can transact. The borrowed capital cannot be taken as a loan out of your brokerage account. The process is similar to the leverage that you use when you purchase a home. When you buy a house, you can go to the bank and get a mortgage. By getting a mortgage, you put some of your money down to purchase a home and use the bank’s borrowed capital for the balance. The collateral is the house. If you cannot pay your bank the borrowed money, they will eventually take the house.

When you use leverage in a forex or CFD brokerage account, the collaterals used are the CFDs and the currency pairs. Your broker will allow you to put up only a portion of the capital needed to purchase a CFD. In some of the more popular currency pairs, you will only need to put up one dollar to control $400. Each broker will require different margins for different instruments – depending on volatility and other factors.

What is a Margin Call?

When the value of your account falls below your broker’s required amount, a margin call occurs. A margin call is a request by your broker for you to add additional funds to your account. Alternatively, you could sell some of the assets you have in your account to raise your cash levels.  Your broker will not take a loss for you, so as the equity in your account shrinks due to market-to-market losses, your broker will require more equity in the form of cash. An investor’s margin account contains securities bought with borrowed money. The additional cash will top up the equity in your account to reach the maintenance margin level.

You should read your margin agreement when you open your brokerage account carefully. The language might state that your broker has the right to liquidate your positions if a margin call is not satisfied in a timely matter. Since your account’s value is based on borrowed capital, you can lose more than the equity in your account.

For example, if you assume you place $1,000 of equity in your account, you take 2-position each with $500 to leverage the positions at 100-1. Each position is worth $50,000 for a total of $100,000. If you lose more than 1%, you will have lost all the equity in your account. Your broker will not allow you to lose more than this amount and, therefore, will require you to increase your equity if the market moves against you.

How Can Leverage Help You

Leverage can help you enhance your returns and provide you with a way to generate income. Using the example where an investor uses a margin of 100-1 on $1,000, if you can generate returns of 1% on your positions, you can increase your overall returns by 100%. Remember, leverage cuts both ways. If you lose 1% of your leveraged positions, you can wipe out all of your equity. If you plan to use leverage when you trade, you should determine the losses and gains based on your position’s value, not the amount of capital you post. For example, you should generate a stop loss level before you take a position as a percent of the position’s total value.

The Bottom Line

The upshot is that leverage helps you enhance your returns using borrowed capital. To use leverage, you will need your broker to provide you with a margin account. The margin account allows you to use the securities in your account as collateral. Depending on the volatility of the securities you trade, your broker will offer you different leverage levels.  It’s important to understand that leverage not only enhances your gains but can accentuate your losses. When you use leverage, you should consider using prudent stop-loss levels.