This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
Leverage is a useful tool for some types of traders and a destructive one for others. The difference is not the leverage itself. The difference is the trader's strategy, the trader's discipline, and the trader's risk tolerance. A trader who uses leverage as a default, on every position, in every market, is taking on risk that the leverage was not designed to deliver. A trader who uses leverage as a tactical tool, in a narrow set of conditions, with a clear stop, is using the leverage as it was designed.
The traders for whom leverage works
The first group is short-term tactical traders. These traders hold positions for hours to days, with a defined entry, a defined stop, and a defined target. The leverage is a tool for sizing the position to the trade, and the position is sized to the dollar risk at the stop, not to the desired return. The leverage is unwound when the position is closed, and the trader is not exposed to the leverage overnight or over a weekend.
The second group is hedgers. These traders use leverage to take a short position against a long portfolio, or to take a long position against a short portfolio, for the purpose of hedging. The leverage is a tool for the hedge, and the cost of the leverage is the financing rate on the borrowed portion. The hedge is closed when the risk window passes, and the trader is not exposed to the leverage beyond the hedge.
The third group is professional or institutional traders. These traders have access to lower financing rates, higher leverage caps, and a more sophisticated risk management framework. The leverage is a tool for portfolio-level positioning, and the trader has the infrastructure to monitor the positions in real time and to react to changes in the market.
The fourth group is prop traders. These traders trade the firm's capital, not their own, and the leverage is a function of the firm's risk policy. The trader is not exposed to personal financial loss beyond the capital allocated to the trader, and the leverage is a tool for generating returns on the firm's capital.
The traders for whom leverage does not work
The first group is long-term buy-and-hold investors. These traders hold positions for months to years, and the leverage is a multiplier on the position's return. The financing cost compounds over the hold period, the daily reset on leveraged products compounds in a way that produces a return below the underlying's, and the position is exposed to a gap that can wipe out months of gains. The leverage is not a tool for long-term investing.
The second group is unhedged directional traders. These traders take leveraged positions in a single direction, and the trader is exposed to the full drawdown on the position. A gap on the position can wipe out a large portion of the trader's capital, and the recovery is not possible from a closed position. The leverage is not a tool for unhedged directional trading.
The third group is new traders. These traders are still learning the market, and the leverage is a multiplier on the trader's mistakes. A new trader who uses leverage is taking on risk that the trader does not fully understand, and the mistakes are amplified by the leverage. The leverage is not a tool for new traders.
The fourth group is overconfident traders. These traders are convinced of their view, and the leverage is a way to take a position larger than the trader's risk budget. The overconfidence is exposed when the market moves against the trader, and the leverage amplifies the loss. The leverage is not a tool for overconfident traders.
How to know whether leverage suits you
The honest answer is to test the strategy with a small amount of leverage, and to evaluate the result over a representative period. A trader who can produce a positive return on a small leveraged position over a few months, with a clear stop and a clear target, is a candidate for larger leverage. A trader who produces a negative return on a small leveraged position is not a candidate, and the trader should stay with unleveraged positions until the strategy is working.
A useful test is to size the position to 1% of the account at the stop, and to use whatever leverage is required to produce that risk. The leverage figure is the result of the position sizing, not the input. The trader who can do this consistently is a candidate for leverage. The trader who cannot is not.
A second test is to evaluate the trader's behaviour in a losing position. A trader who closes a leveraged position at the stop, takes the loss, and moves on to the next trade is using leverage correctly. A trader who moves the stop, adds to the position, or refuses to close the position is using leverage incorrectly, and the trader should not be using leverage.
How to graduate to more leverage
The graduation is a function of the trader's track record, the trader's discipline, and the trader's capital. A trader who has a positive track record on small leveraged positions over six to twelve months, who closes positions at the stop, and who has the capital to meet a margin call is a candidate for larger leverage. The graduation is incremental, and the trader should increase the leverage by a small amount (0.5× to 1×) at a time, not jump to the maximum.
The trader's regulator may have a leverage cap that is below the broker's maximum. The cap is the legal limit, and the trader should not exceed it. The broker may also have an internal cap that is below the regulator's cap, and the trader should respect it. The caps are in place to protect the trader, and the trader should not work around them.
Related resources
Where to start
If you are evaluating whether leverage suits you, the most useful exercise is to test the strategy on a small leveraged position. Our broker comparison lists the leverage available at each broker and the regulator that supervises the account, which together tell you what is on the table before you size the position.