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 in stock trading amplifies both the upside and the downside of a position, and the risks are several. The most common risks are amplified losses, margin calls, financing costs, gap risk, and the behavioural trap. The risks are more common than the corresponding rewards, and the most common trader mistake is to use leverage to take a position larger than the unleveraged one would have been. The result is a position that is harder to manage and more likely to be closed at the worst moment.
The amplified loss
The first risk is the amplified loss. A 2× leveraged position that loses 10% produces a 20% loss on the trader's capital. A 5× leveraged position that loses 10% produces a 50% loss. A 50% loss requires a 100% gain to recover, and most traders cannot produce a 100% gain in the time available.
The amplified loss is most punishing in a fast market. A position that gaps down at the open can move 10% or more in a single session, and the leveraged loss on the trader's capital is 20% or more for a 2× position. The gap is the most common cause of large account losses for retail traders using leverage.
The fix is to size the position to the stop and the account, not to the desired return. The leverage figure is whatever the position size requires, not a goal in itself.
The margin call
The second risk is the margin call. A leveraged position that moves against the trader can fall below the maintenance margin, and the broker will issue a margin call. The trader who does not respond is forced to close the position at the worst available price, and the loss is locked in.
The margin call risk is most acute in a fast market, where the position can move through the maintenance margin level before the trader has a chance to react. The trader is left with a smaller account and a worse view of the market.
The fix is to size the position to the maintenance margin, not the initial margin. 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.
The financing cost
The third risk is the financing cost. A leveraged position held overnight pays a financing rate on the borrowed portion, and the rate accrues daily. A 5% annual financing rate on a 2× leveraged position is roughly 5% per year on the trader's capital, paid daily.
The financing cost is the most common reason that leveraged positions underperform unleveraged positions over long horizons. The cost is not visible in the daily P&L, but it shows up in the year-end return.
The fix is to hold the leveraged position for a short period, where the financing cost is small. The trader who holds the position for a few days pays a fraction of a percent in financing cost, and the cost is offset by the return on the trade.
The gap risk
The fourth risk 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 before the trader has a chance to react. The rebalance did not happen, and the trader's stop did not fire at the right level.
The gap risk is most acute over a weekend, a holiday, or a known event. The trader is exposed to the gap for the entire closed period, and the leveraged position amplifies the gap. The fix is to be out of the position over a known event, or to size the position to the gap risk rather than the daily risk.
The fix is also to set the stop on the previous close, not on a level that assumes a smooth open. A trader who sets the stop at a level that assumes the price will respect the level during a gap is exposed to a worse fill than the stop suggests. The trader who accepts that gaps can happen and sizes the position to the gap is using leverage correctly.
The behavioural trap
The fifth risk is the behavioural trap. A trader who is up on a leveraged position is reluctant to take the profit, because the return feels too small for the leverage. A 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, often with the trader adding to the position at the worst moment.
The behavioural trap is the most common reason that small losses become large losses. The trader who closes a leveraged position at the stop, takes the loss, and moves on to the next trade is using leverage correctly. The trader who moves the stop, adds to the position, and watches the loss grow is using leverage incorrectly, and the trader is the one who is exposed to the large loss.
The fix is to set a target and a stop before the trade is opened, and to honour them when the price reaches them. The discipline is the same as for an unleveraged position, but the stakes are higher. A trader who is using leverage should be more disciplined, not less, and the discipline is the only way to make the leverage work in the trader's favour.
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.