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 basic tool in stocks trading, and its role is to make the position efficient. A trader who uses leverage to take a position larger than the unleveraged one is using it as a bet amplifier, exposing the trader to the asymmetric risk profile. The profile is the result of compounding losses, most pronounced in fast markets and over long horizons.
The efficient use of leverage
The efficient use of leverage is to take a position sized to the trader's stop and the trader's account. The trader who has a €10,000 account, a 1% risk per trade, and a stop 5% away from entry needs a position size that produces a €100 loss at the stop. The leverage figure is whatever the position size requires, not a goal in itself. The trader who does this consistently produces a return that is consistent with the strategy's win rate and risk-reward ratio.
The efficient use of leverage is also a function of the holding period. A trader who holds a position for a few days pays the financing cost for a few days, and the cost is small. A trader who holds a position for a year pays the financing cost for a year, and the cost is meaningful. The day trader can use leverage without paying the long-term cost, and the long-term investor should use less leverage or none at all.
The efficient use of leverage is also a function of the strategy. A trader who is hedging a portfolio can use leverage to take a short position without committing additional capital, and the hedge is a clean use of the leverage. A trader who is taking a directional bet should size the bet to the stop and the account, and the leverage figure is the result of the position sizing.
The bet amplifier use of leverage
The bet amplifier use of leverage is to take a position larger than the trader's risk budget. The trader who has a €10,000 account and a 1% risk per trade takes a position with €1,000 of risk at the stop. The trader who uses 10:1 leverage and a 5% stop takes a €20,000 position with €1,000 of risk at the stop, and the position is 2× the unleveraged size. The bet is 2× the trader's plan, and the bet is exposed to the asymmetric risk profile of leverage.
The bet amplifier is the most common use of leverage among retail traders, and it is the one that produces the largest losses. The trader who takes a position larger than the plan is exposed to a drawdown that exceeds the risk budget, and the drawdown can trigger a margin call. The margin call is the broker's way of saying the equity is no longer enough to support the loan, and the forced close is the worst outcome.
The bet amplifier is also the use of leverage that is most vulnerable to the behavioural trap. The trader who is up on a leveraged position is reluctant to take the profit, because the return feels too small for the leverage. The trader who is down on a leveraged position is reluctant to take the loss, because the loss feels too large for the trade. The result is a position that is held too long in both directions, and the position is exposed to a forced close at the worst moment.
The asymmetric risk profile of leverage
The asymmetric risk profile of leverage is the result of two effects. The first is the compounding of losses. A 5% loss on a 2× leveraged position is a 10% loss on the trader's capital, and the 10% loss requires an 11.1% gain to recover. The compounding is small per trade, but the compounding is large over many trades, and the compounding is the most common reason that leveraged traders underperform unleveraged traders over long horizons.
The second is the gap risk. A leveraged position is revalued at the close, but the trader may hold through a gap at the next open. A 3% gap down on the underlying produces a 6% loss on a 2× leveraged position, and the 6% loss is larger than the daily multiplier would suggest. The gap risk is most acute over a weekend, a holiday, or a known event, and the gap risk is the most common cause of large losses for retail traders using leverage.
When to use leverage in stocks trading
The honest answer is to use leverage for short-term tactical positions, hedging, and capital efficiency. The trader who uses leverage for a long-term hold pays the financing cost for the entire period, and the cost is a real drag on the return. The trader who uses leverage for an unhedged directional bet is exposed to the full drawdown, which can exceed the risk budget.
The trader who uses leverage for a short-term tactical position is using it correctly. The position is sized to the stop, the hold is short, and the financing cost is small. The trader who uses leverage for a hedged position is using it correctly. The hedge is sized to the exposure, and the cost is the financing rate. The trader who uses leverage for a long-term hold is using it incorrectly, and is paying for a more stressful experience.
How to size leverage correctly
The honest answer is to use whatever leverage is required to produce the correct dollar risk at the stop, not a specific leverage figure. A trader who has a €10,000 account, a 1% risk per trade, and a stop 5% away from entry needs a position size that produces a €100 loss at the stop. The leverage figure is whatever the position size requires, not a goal in itself.
The second answer is to size the leverage to the maintenance margin, not the initial margin. A trader who sizes the position to the initial margin alone has no buffer for a gap, and the gap triggers a margin call. A trader who sizes the position to a 20% gap on the position has a buffer for most gaps, and the margin call is less likely to fire.
Related resources
Where to start
If you are evaluating leverage for your strategy, the most useful exercise is to calculate the dollar risk at the stop, and to use the leverage required to produce that risk on a small 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 open the position.