Leverage is a trading tool that enables you to control a large amount of capital without paying for the full value of your position upfront. Several financial products make use of leverage, including futures, options, and forex trades.
Instead of paying for the total value of a leveraged trade, you put down a smaller amount known as your margin. When buying $10,000 of EUR/USD, for example, you might only have to put down 5% of your position’s value as margin ($500).
Your profit or loss would still be based on the $10,000, however. It's important to remember that leverage will magnify both your profits and your losses.
What is a leverage ratio?
A leverage ratio is a calculation that tells you how much leverage you're employing on a trade. A leverage ratio of 1:20, for instance, means that every dollar you deposit as margin will control $20 in your position.
In our EUR/USD example, paying a margin of 5% means you're trading with a leverage ratio of 20:1.
In fundamental analysis, meanwhile, you might use a leverage ratio to calculate how much of a company's capital is borrowed. A business with a high leverage ratio could struggle to repay its debts when they are due.