Leverage and Margin Explained: How Borrowed Money Amplifies Risk

Leverage lets you control a position larger than your cash. It magnifies gains and losses equally. Used carefully, it can make a strategy more capital-efficient. Used carelessly, it is one of the fastest ways to lose an account.

How leverage works

If you control $100,000 of exposure with $20,000 of your own money, your leverage is 5 to 1. A 2% move in the position is a 10% change in your equity.

Different markets provide leverage differently:

• Stocks on margin. In the US, Regulation T generally allows borrowing up to 50% of the purchase price for initial margin, with ongoing maintenance requirements set by FINRA and brokers. See FINRA's margin guidance.
• Futures. You post a performance bond, often a small fraction of the contract's value, set by the exchange and your broker.
• Forex and CFDs. Leverage is often high. Regulators in many regions cap it for retail clients. See CFD trading explained.
• Options. Leverage is built into the instrument: a small premium controls 100 shares.

Margin calls

If losses reduce your equity below the maintenance margin, your broker issues a margin call. You must add funds or reduce positions. If you do not, or if the market moves fast, the broker can close positions for you, often at poor prices.

Think in risk, not buying power

The amount you can trade is not the amount you should trade. Buying power tells you what the broker allows. Your risk per trade should still come from your stop and your position sizing:

• Decide the risk you accept, such as 1% of equity.
• Set your stop.
• Size the position so the stop equals that risk.

If that position uses only a small part of your buying power, good. Leverage you do not use cannot hurt you.

Hidden leverage

• Correlated positions add up. See correlation risk.
• Overnight and weekend gaps can move price past your stop.
• Short options can have losses much larger than the premium received.

Track your exposure

Know your total notional exposure relative to equity. TradeThink's open positions page shows each position's value and P&L, and the cash flow page shows deposits, withdrawals and fees, so you can see how your real equity has changed. Related: maximum drawdown.