Leverage is essentially money that you will borrow from the broker and with that it is a responsibility to maintain a minimum balance of your own money inside of the trading account so you will be able to cover any potential loss that may occur.
When using leverage to buy derivatives or trade in Forex or any other financial instrument, you may be subjected to a margin call which that your loss is big enough so your own money versus the money borrowed from brokers is becoming insufficient to maintain your position(s) opened in your trading account.
Your initial Capital is $50,000.
Your goal is to Buy 1,000 shares XYZ Company at $150 each.
If you don’t want to use leverage you need to have $150 X 1,000 shares = $150,000.
As you only have $50,000 you go to your broker and ask him to provide you with 2:1 leverage which means 3 times your initial capital (you add $100,000 to your $50,000)
Now you have $150,000 and have the ability to buy 1,000 shares XYZ at $150/each.
Two scenarios occur:
1- If shares increase from $150 to $180 then profits are 1,000 x (180-150) = $30,000.
2- If Shares Decrease from $150 to $120 then loss will be 1,000 x (150-120) = $30,000.
Leverage means that using $50,000 of initial capital, the profit came at $30,000, or an ROI of 60%.
ROI = (30,000/50,000)*100= 60%
While without using leverage you will need the full $150,000 to be available in your bank account, which as an investor, you might not have available, forcing you to withdraw from this investment, subsequently missing on the opportunity.
At the same time if you calculate the return on investment (ROI) when you invest the full $150,000 you will get an ROI of 20%. ROI = (30,000/150,000)*100= 20% only.
Now consider the case of a drop in share price with a leveraged investment.
The same margin of loss will be applicable whereby an investor would be subject to a loss of $30,000 from an initial investment of $50,000; i.e. a 60% loss of the initial capital.
With loss on leverage comes a margin call, which is the process that involves the investor adding more funds to cover losses in their leveraged position. In the example given out above, the investor might have a margin call on 50% of the initial capital.
For that reason, the investor will have an option to either add new money to their account, or be forced to close the position. Once the position is closed, there is no profit even if the stock increases back to price higher than $150 at a later stage.
In case of a non-leveraged account, i.e. using full cash amount, the loss will only be 20% from the initial capital. Leveraging is a risky form of trade; therefore we suggest that all investors understand fully the associated risks before being drawn into any such form of financial investments.