The clue is in the name. Just as a mechanical lever helps you move a heavy load with only a small amount of force, leverage enables you to gain a large exposure to a financial asset using only a small amount of your trading capital.
When you buy an asset in the traditional way, you generally need to pay the full purchase price up front: the total value of the shares, currency, barrels of oil or whatever you're trading. However, some providers offer the facility to trade using leverage, which means you only have to put up a fraction of the value of your position. Effectively, your provider lends you the rest of the purchase price.
This means that any profit you make, which is still based on the full value of the position, appears magnified in comparison to your outlay. The flip side of this is that any losses are magnified in the same way.
How does it work?
Let's have a look at an example to illustrate this.
Suppose you decide to buy 1000 shares in Tech Giant Inc. The share price is $1, so to open a conventional trade with a stockbroker you pay 1000 x $1 = $1000. (We'll ignore any commission or other charges to keep this example simple.)
Alternatively, you could decide to trade using a provider that offers leverage facilities. The provider will ask you to pay just a percentage of the full $1000 to open your trade. This is known as a margin or deposit requirement, and the actual percentage will vary from asset to asset, and from provider to provider.
Say your provider has set the margin requirement for Tech Giant Inc at 10%. This means you need to pay only 10% x $1000 = $100 to open your position. You still have exposure to 1000 shares, but at a tenth of the initial cost.
Magnified profits and losses
Now let's see what happens as your Tech Giant Inc trade progresses.
Your decision to buy these shares was shrewd as the price now climbs to $1.20. You sell to close your trade for $1.20 x 1000 = $1200, giving you a profit of $200.
It's vital to prepare yourself for situations like this by always keeping in mind the full value of your trade, and the potential for loss, when you're using leverage.
This is particularly true in markets such as forex, where you deal in lots that can each be worth thousands of units of currency. At the same time, margin rates can be very low.
So if you were to sell just one standard lot of 100,000 units of EUR/USD at 1.2910, the contract value would be $129,100. With a potential margin requirement of just 0.5%, your deposit for this very substantial trade would only be $645.50. It's easy to forget how much capital is at risk when the initial outlay is so affordable.
