Leverage and Margin Explained: How They Work and the Risks

Leverage is the use of borrowed money to increase the size of a position beyond what your own cash alone could fund. Margin is the collateral you must deposit to borrow that money. Together they magnify both gains and losses on the same price move, which is why leverage cuts in both directions.

What is leverage in trading?

Leverage in trading is the use of borrowed capital to control a position larger than your own funds would allow. It is usually expressed as a ratio, such as 2:1, 5:1, or 10:1, comparing the total position size to the equity backing it. A 5:1 ratio means that for every $1 of your own money, you control $5 of market exposure.

The appeal is obvious: leverage lets a small account take a larger position and, if the trade moves in its favor, earn a larger return on the cash deposited. The danger is symmetric. Leverage does not change the size of the price move; it changes how much of your own equity that move represents. As the Wikipedia entry on leverage puts it, leverage magnifies any profit or loss made on the position. Understanding that symmetry is the whole point of this glossary entry.

What is margin?

Margin is the collateral you deposit with a broker to open and hold a leveraged position. The SEC's plain-language definition describes margin as borrowing money from a broker to purchase securities, using your own cash or securities as collateral for the loan. Margin is the "skin in the game" that protects the lender if the trade moves against you.

There are two figures that matter. Initial margin is the minimum equity required to open a position. Under the Federal Reserve's Regulation T, a US broker can lend up to 50% of the purchase price of a stock, so the initial margin is at least 50%. Maintenance margin is the minimum equity you must keep in the account afterward. Per FINRA rules, your equity must not fall below 25% of the current market value of the securities, and many brokers set stricter "house" requirements above that floor.

How does a leverage ratio work? (a worked example)

A leverage ratio compares total position size to the equity behind it, and it directly scales the percentage return on your deposit. The simplest way to see it is to run the same 10% price move through three different ratios and watch what happens to your own money.

Suppose you have $1,000 of equity. With no leverage (1:1), you control $1,000 of exposure. With 5:1 leverage, the same $1,000 controls $5,000 of exposure. With 10:1 leverage, it controls $10,000.

Now apply a 10% favorable move:

• 1:1: $1,000 x 10% = $100 gain, a 10% return on your equity.
• 5:1: $5,000 x 10% = $500 gain, a 50% return on your equity.
• 10:1: $10,000 x 10% = $1,000 gain, a 100% return on your equity.

The borrowed money does not change the 10% move. It changes how much that move is worth relative to the $1,000 you actually put up. The catch is that an adverse 10% move produces the mirror image: a $500 loss at 5:1 wipes out half your equity, and a $1,000 loss at 10:1 wipes out all of it before fees.

What is a margin call?

A margin call is a demand from your broker to add funds or close positions when your account equity falls below the maintenance margin requirement. It happens after a leveraged position moves against you far enough that your collateral no longer covers the lender's risk. The broker is asking you to restore the cushion.

You may get only a short window to respond, sometimes hours, and sometimes none at all. Critically, FINRA notes that a firm can sell the securities in your account to cover a shortfall without notifying you first, and you are not entitled to choose which holdings are liquidated or to receive an extension. Forced liquidation often happens at the worst possible price, locking in the loss.

How is a margin call triggered? (the math)

A margin call triggers when equity divided by position value drops below the maintenance margin percentage. Say you buy $10,000 of stock with $5,000 of your own cash and $5,000 borrowed (2:1 leverage, 50% initial margin). Your equity is $5,000. If the broker's maintenance margin is 25%, you can hold the position as long as your equity stays above 25% of the current market value.

If the stock falls 30% to $7,000, the $5,000 loan is unchanged, so your equity is now $7,000 minus $5,000, or $2,000. That is about 28.6% of the $7,000 position, still above 25%, so no call yet. A further drop to $6,600 would put equity at $1,600, or roughly 24.2%, below the 25% floor, triggering a margin call. The borrowed portion never shrinks, so every dollar of decline comes straight out of your equity.

How is leverage different across markets?

Leverage looks very different depending on the asset class, because each market sets its own margin rules. Stocks are the most conservative; derivatives and currencies allow far higher ratios, which means far faster gains and losses.

Higher available leverage is not a benefit to chase. In currency markets especially, a small move against a highly leveraged position can erase an account quickly. If you trade forex, our pip value calculator helps you translate a leveraged position size into the actual dollar value of each price tick, so the risk is concrete before you commit.

Why is leverage so risky?

Leverage is risky because it amplifies losses just as efficiently as gains, and a large enough loss can exceed your entire deposit. The same 5:1 ratio that turns a 10% gain into a 50% return turns a 10% loss into a 50% drawdown, and a 20% adverse move wipes out the account entirely. There is no version of leverage that boosts upside without enlarging downside by exactly the same factor.

Two compounding hazards make it worse in practice. First, borrowing is not free: margin loans charge interest, and holding a leveraged position over time slowly erodes returns. Second, leverage shrinks your margin for error. A position you could have held through normal volatility unleveraged may hit a margin call when leveraged, forcing you out at a loss right before a recovery. This is why position sizing and predefined exits matter more, not less, when leverage is involved. Our guide to trading risk management covers how to size positions so a single leveraged trade cannot threaten the account.

Putting leverage and margin in context

Leverage and margin are tools, not strategies. They let a given amount of capital take a larger position, which is useful for capital efficiency and hedging, but they add nothing to the quality of the underlying idea. A leveraged bad decision simply loses money faster. The traders who use leverage durably treat it as a controlled dial tied to a strict risk budget, keep plenty of free equity as a buffer against margin calls, and understand the exact math of what an adverse move does to their account before they ever open the position.