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, sometimes called the multiplier effect, is the use of borrowed capital to increase the potential return of an investment. The trader puts up a fraction of the position value, and the broker lends the rest. A 1 percent move in the underlying stock becomes a 5 percent move on a 5:1 leveraged position, and a 1 percent move becomes a 20 percent move on a 20:1 leveraged position. The same multiplier works in both directions, and the same multiplier amplifies the losses.
The mechanics of the multiplier
The multiplier is the ratio between the position size and the margin. A 5:1 leverage means the position is five times the margin. The trader who has €10,000 in the account and uses 5:1 leverage can control a €50,000 position. A 1 percent move on the €50,000 position is €500, which is 5 percent of the €10,000 margin.
The margin is the deposit the broker requires to open the position, and the margin is not a fee. The margin is held by the broker as collateral, and the margin is released when the position is closed. The trader who holds the position overnight pays a financing charge on the borrowed amount, and the financing charge is a percentage of the position value per year.
The margin call happens when the position moves against the trader and the account equity falls below the maintenance margin. The broker sends a margin call, and the trader must deposit additional funds to keep the position open. The trader who does not deposit the funds has the position liquidated by the broker.
Where the multiplier applies
The multiplier applies to CFDs, futures, and options. CFDs are leveraged by default, and the broker sets the leverage based on the underlying asset and the regulator's rules. Futures are leveraged through the margin system, and the leverage depends on the contract and the exchange. Options are leveraged through the premium, and the leverage is highest when the premium is small relative to the underlying price.
The multiplier does not apply to direct stock purchases. A trader who buys €50,000 of a stock with €10,000 in cash has to fund the €50,000, and the broker does not lend the difference. The trader who wants leverage on direct stock purchases can use a margin account, and the broker lends a portion of the purchase price.
The practical rules for sizing
The first rule is to size the position to the risk, not to the available margin. The trader who risks 1 percent of the account on a single trade should size the position so that a stop-loss at 1 percent of the entry produces a 1 percent loss on the account. The trader who uses 10:1 leverage and 10 percent of the account on a single trade is risking the entire account on a 10 percent move.
The second rule is to use a stop-loss. The stop-loss limits the loss, and the stop-loss is the trader's main tool for managing the risk of a leveraged position. The stop-loss should be placed at a level that matches the trader's risk tolerance, and the stop-loss should not be moved against the trader.
The third rule is to monitor the margin level. The trader should check the margin level regularly, and the trader should not let the margin level fall below the broker's minimum. The trader who holds multiple positions should add up the margin requirements, and the trader should keep a buffer for adverse moves.
The risks of the multiplier
The first risk is the loss amplification. The leverage that produces a 5 percent gain on a 5:1 position can produce a 5 percent loss, and the loss can be larger than the gain because of the spread, the commission, and the financing charge. The trader who uses high leverage can lose the entire deposit on a single trade.
The second risk is the margin call. The margin call can happen at any time, and the broker can demand additional funds within hours. The trader who does not have the additional funds has the position liquidated at the worst possible time, and the trader realizes the loss.
The third risk is the over-trading. The leverage makes the positions look more attractive, and the trader may be tempted to take larger positions than the trader's risk tolerance allows. The trader should set the risk rules before opening the position, and the trader should stick to the rules.
Common questions about the multiplier effect
What is the maximum leverage available? The maximum leverage depends on the regulator and the broker. In the European Union, the maximum leverage for retail clients is 1:30 on major forex pairs and 1:5 on stocks. Off-shore brokers can offer higher leverage, but the higher leverage comes with a lower level of protection.
Can I lose more than my deposit with leverage? Yes, with CFDs and futures. The position can move against the trader, and the broker can demand additional margin. The trader who does not have the additional funds has the position liquidated, and the trader may still owe the broker the difference.
Is the multiplier effect the same as options leverage? The options leverage is a function of the premium relative to the underlying price, and the options leverage changes as the underlying price moves. The CFD and futures leverage is fixed by the broker or the exchange, and the leverage does not change during the trade.
Related resources
Where to start
If you are evaluating the multiplier effect for stock trading, the most useful first step is to open a demo account at a regulated broker, and to place a small leveraged trade on a stock you follow. Our broker comparison lists the brokers that offer leveraged trading and the available leverage, which together tell you what the broker offers before you place the first leveraged trade on a live account.