Leverage is a way of maximising your exposure to a given market by borrowing capital from your broker. It’s effectively a multiplier that allows you to trade a larger position than the money in your trading account would otherwise allow. Leverage is expressed as a ratio, so for example, a trader with $1000 who is trading on 1:100 leverage can theoretically hold a position that is 100x larger ($100,000).
The type of trading account that allows you to do this is called a margin account. Margin is simply the amount you must hold in your account, essentially as collateral, in order to guarantee a trade of a given size.
Leverage and margin are basically different ways of saying the same thing. So, in the above example, trading on 1:100 leverage is the same as saying that your account’s margin requirement is 1% (in other words, you're only required to hold 1% of the size of the position you’re trying to open as collateral). Similarly, a 2% margin requirement is the equivalent of 1:50 leverage, and a 5% margin requirement is the same as 1:20 leverage.
You can translate leverage to margin requirement using the following equation.
Margin = 1 / Leverage
So, assuming a leverage ratio of 1:100, dividing 1 by 100 (our leverage ratio) equals 0.01, or 1% as we saw above.
The following equation translates the margin requirement into a leverage ratio.
Leverage = 1 / Margin
Now, assuming a margin requirement of 2% in this next example, if we divide 1 by 0.02 (our margin requirement converted to decimal), we get 50, or a 1:50 leverage ratio, as mentioned above.
For obvious reasons, leverage multiplies losses in the same way it multiplies gains, so it should always be used with care. Consider that if every change in price to the upside is multiplied by 100 (in the case of 1:100 leverage), then every change in price to the downside is also multiplied in the same way.
When trading with leverage, it's easy to stay in a position that’s moving in your favour (because the leverage is multiplying your potential profits), however, a trade that is moving against you can quickly wipe you out. This is because your losses are being multiplied, too, which can rapidly take your account below its minimum margin requirement. This then requires you to post more collateral or have your position automatically closed.
In a market that's quickly moving against you, using leverage can lead to your position being stopped-out (closed automatically), before you have a chance to do anything about it. The most frustrating part of over-leveraging, is that you may even be right about the general direction that the market is moving in, but if you use too much leverage, then even a small dip in the opposite direction of your trade can stop you out before the market continues in the direction that you were predicting. For these reasons, leverage should be used prudently, with a well capitalised account, and a sound risk management strategy. Capitalisation is important because the larger your account balance relative to the leverage you're using, the more of a cushion you have should a leveraged trade start moving against you.