Leverage
Leverage magnifies gains and losses in the same proportion and shortens the path to a forced close. At leverage 20, a five percent price drop is enough to lose everything.
Learning objective: After this lesson you can calculate which price drop wipes you out at a given leverage.
With leverage you move more money than you have. If Kai puts in €1,000 at leverage 10, he's moving €10,000. If the price rises one percent, he gains ten percent of his stake, so €100.
Why Leverage Magnifies Losses
Everyone understands that part. Many overlook the other. If the price falls one percent, Kai loses ten percent. If it falls ten percent, his whole €1,000 is gone.
The Formula Behind It
The formula is simple: a hundred divided by the leverage gives the price move that wipes you out completely. Leverage 20 means five percent. Leverage 50 means two percent.
Normal Price Moves
Two percent in a day is quite normal in many markets. In cryptocurrencies, ten percent in a day is nothing special. So high leverage there isn't a bold bet. It's usually just a matter of hours until it catches you.
An example trade with made up numbers
Mark puts up €1,000 as collateral and trades a stock index with 10x leverage. That way he moves €10,000. In this example his provider charges about €2 in financing for every night he holds the position.
The index rises 2 percent: Mark gains €200, which is 20 percent of his collateral.
The index falls 2 percent: Mark loses €200, also 20 percent.
The index falls 6 percent: €600 is gone. His collateral barely covers it, and the provider can close the position before Mark decides anything himself. If the index falls 10 percent, the whole collateral is lost.
If Mark holds the position for a month, the nights alone cost him about €60. So the index has to rise 0.6 percent before Mark is even in profit.
Leverage multiplies the return on your own money by the leverage factor, while the price moves just as it would without. The threshold for a forced close lies roughly at a price move of one divided by the leverage. In reality it's a bit closer still, because financing costs and fees come on top.
Volatility Grows Quadratically
There's also a less well known effect. The swings in your account grow with the square of the leverage, the expected gain only proportionally. Double the leverage and the expected gain doubles, but the variance quadruples. Because swings reduce the growth rate you actually achieve, there's a level of leverage above which your account grows more slowly even though the expected gain rises. Go higher still and it shrinks in the long run, even if the expected value is positive.
Daily Reset Products
With leveraged products that reset their leverage every day, there's one more thing. The leverage is applied to the new level each day. Over several days the result therefore isn't simply a multiple of the price move. An example with leverage 2: the index falls 10 percent one day and rises 11.1 percent the next, so it's back where it started. The product first falls 20 percent and then rises 22.2 percent. It ends at just under 98 percent. In markets that swing back and forth, such products therefore keep losing value.
Data as text
The price drop that causes a total loss is 100 percent at 1x leverage, 50 percent at 2x, 20 percent at 5x, 10 percent at 10x, 5 percent at 20x, 2 percent at 50x, and 1 percent at 100x.
Try leverage for yourself
Summary
- A hundred divided by the leverage gives the price drop that wipes everything out.
- Swings grow much faster than the expected gain.
- Daily reset leveraged products lose money in sideways markets, even without a wrong direction.
Did you get it?
At what price move is your stake gone at leverage 25?
At four percent, because 100 divided by 25 is 4.
Why does an account grow more slowly above a certain leverage?
Because swings grow with the square of the leverage, the expected gain only proportionally. The swings reduce the actual growth rate.
What happens to daily leveraged products in sideways markets?
They keep losing value, because the leverage is applied to the new level every day.
Check your understanding
Your task
You put in $2,000 with leverage of 25. Work out the price drop in percent that wipes out your stake on paper, and how many dollars you are moving in total. Check your result in the leverage calculator and find out at which leverage a drop of just two percent is enough.
Sources and further reading
- The European Securities and Markets Authority (ESMA) has introduced binding leverage limits for retail CFD trading, between 30:1 and 2:1 depending on the volatility of the underlying asset, a sign of how seriously regulators take the risk of high leverage. View source ↗
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