Understanding Leverage in Trading

One of the main features of CFD and forex trading is the ability to utilise leverage. But before you get started, it's worth learning exactly how leverage and margin work.

What is leverage?

Leverage is a trading tool that allows you to gain exposure to a larger market position with a relatively small initial outlay. Instead of paying the full value of a trade upfront, you only need to provide a deposit known as margin.

For example, with leverage of 50:1, €1 of margin can give you exposure to a position worth €50.

Leverage is widely used across markets such as forex, indices and commodities, enabling traders to access greater market exposure without committing large amounts of capital. However, while leverage can increase potential returns, it can also magnify losses, making effective risk management essential.

What is margin?

Margin is the capital that you'll have to put down to open a leveraged trade. Different markets will have different margin requirements. You might have to pay 20% of the full value of a shares position, for example – while you could only have to put down 5% with FX.

CFD trading is a popular way of accessing leverage when buying and selling shares, indices, forex and more. Let's examine how it works in practice.

Leverage example: share trading vs CFDs

As you can see in the above example, margin will multiply both your profits and your losses. Because of this, using orders as part of a comprehensive risk management plan is crucial when using leverage. We'll cover this in more detail in the Strategies and risk course.

Margin calls

You'll always need to ensure that you have enough margin in your account to cover the cost of your open trades. If you don't, then you could quickly find yourself on a margin call, which means your positions will be at risk of being closed out.

If you drop below 50% of your margin requirement, your position will be closed automatically.

Returning to our example, say that company XYZ's share price drops to €2.20. Your running loss from the trade would be €300, which would mean that you have less than half of the €500 required to maintain your position. At this point, you'd be at risk of seeing it get automatically closed.

This is to prevent your losses from becoming too large.

If you get placed onto a margin call, we'll let you know via email. At this point, you have three options:

1. Close out your position
2. Reduce the size of your trade to free up some equity in your account
3. Add additional funds to your account to cover the shortfall in margin plus additional funds to sustain any further losses

If you leave your position and it drops to 50% of margin, we'll close it automatically.

Leverage costs

As with standard investing, you'll have to pay to open a leveraged trade – via either commission or the spread. When you pay via the spread, the costs of your trade are incorporated into the bid and ask prices. With commission, they are separate.

You'll also pay borrowing costs on positions that you keep open for more than a single day. This is called overnight financing.

Overnight financing is essentially an interest payment to cover the cost of your leverage. At FOREX.com, we charge 2.5% above or below €STR (or an equivalent interest rate), depending on whether you have a long or short position open.

On positions with no expiry, overnight financing will be charged each day that your trade is open. With forwards, the cost of financing is already incorporated into the spread, so you don't have to pay each day.

Calculating overnight financing

To calculate overnight financing on a long position, you take its size at the end of the day and multiply it by €STR plus 2.5%. Then you divide that figure by 365 to get a daily rate.

Did you know? You don't have to calculate the financing charge manually whenever you trade. On the FOREX.com platform, you can see the overnight financing charge for any market by looking at the Market Info tab.

Say you own 1000 CFDs at €4.50 at the end of the trading day and €STR is 3%.

1. Your position is worth €4500
2. €STR + 2.5% = 5.5%
3. 5.5% of €4500 = €247.50
4. €247.50 / 365 = €0.68

When shorting, meanwhile, the calculation is the same – except that you minus 2.5% off €STR instead of adding it. Your account may be credited with the overnight financing fee, depending on interest rates.

1. Your position is worth €4500
2. €STR - 2.5% = 0.5%
3. 0.5% of €4500 = €22.50
4. €22.50 / 365 = €0.06