As a key feature of financial trading, leverage allows traders to control larger positions with smaller deposits. Designed to allow traders to maximise profits even with small market price movements, leverage is a powerful trading tool that increases both opportunity and risk.
Poor risk control leading to potentially large losses is the primary risk of leverage. This article outlines a range of practical risk management tools, strategies and approaches that can be utilised by traders at all levels to minimise risk and maximise opportunities associated with the concept of leverage.
We also detail the most common mistakes made when trading with leverage to support trading education at all levels.
What Is Leverage Risk in Trading and Why It Matters
The risk of leverage lies in the fact that leverage can increase the risk of loss, sometimes on a major scale. As leverage amplifies price movements and magnifies any potential losses, if prices move against your trades then losses can increase rapidly.
When utilising leverage as a trading tool, it’s usually advisable to start small and gradually increase to a higher ratio.
Starting small and working your way up will ensure a deeper level of understanding regarding leverage risk management. This is because even small market moves can have outsized effects on account equity and lead to major losses relative to your margin.
Leverage Risk in Trading Across Different Markets
Leverage risk behaves very differently from market to market with regards to volatility, liquidity and gap risk.
The forex markets typically see high liquidity and tighter spreaders for smoother, more predictable price action. However, leverage is usually high on forex trades therefore open positions may be more vulnerable to sudden, unexpected losses as per the fast-paced nature of the market.
Trading with leverage using stocks is usually done with lower leverage but it's subject to a greater gap risk as prices can spike suddenly following earnings reports or significant news and events.
Indices are also subject to higher volatility during economic news and releases – they usually offer strong liquidity but this vulnerability in volatile market conditions can lead to short-term price swings and losses.
CFDs behave slightly differently because they track underlying assets but also offer opportunity for high leverage. This means the potential impact of volatility and the gap risk need to be considered carefully when managing leveraged positions using CFDs.
Broadly speaking, the financial markets are subject to high volatility and sudden movements at any time, meaning stock market leverage risk spike is a real possibility and can lead to major losses. This makes stringent and tailored risk management an absolute must for traders at all levels.
Leverage Trading Risk Management Techniques That Actually Work
While leverage can increase profit potential, it also raises the risk of margin calls and account liquidation, making disciplined risk management and position sizing critical.
Consider Position Sizing Carefully
Taking the time to choose your position size is essential when trading with leverage. This means considering your total account capital alongside your maximum risk per trade to ensure that no individual trade will unduly impact your overall trading capital in the event of loss.
Apply Stop-Loss Discipline
Stop-loss orders are an integral part of leverage trading risk management, allowing traders to automatically cap losses by closing positions if the price falls to a pre-determined level. This level is the maximum loss the individual can tolerate per trade.
As stop-loss orders can be subject to slippage during volatile and fast-moving market conditions, some traders also like to use guaranteed stops. This risk management tool stops trades at the exact price specified regardless of market conditions for an extra level of security.
Limit Leverage Per Trade
Setting leverage limits per trade in line with personal risk appetite is essential. This reduces exposure to sudden price movements, slippage and unexpected volatility for an (ideally) more consistently performance.
It also allows for wider stop losses and goes hand in hand with avoiding overexposure as a core risk management principle when trading leveraged positions.
Avoid Overexposure
Overtrading is a key risk when trading with leverage, where the temptation of higher potential profits leads to unhealthy trading decisions such as overexposure or opening too many positions simultaneously.
This makes it harder to effectively manage leveraged positions and can lead to unnecessary losses prompted by emotional decision-making.
Common Mistakes That Increase Leverage Risk in Trading
There's a great range of tools and strategies available to reduce the risk of leverage but it’s also important to be aware of some of the most common mistakes that can increase risk – and how to avoid them.
These errors are all centred predominantly around behavioural risk rather than technical mistakes which means consistently investing in good trading practice will go a long way to supporting a positive trading journey.
This includes starting small with leverage and working your way up slowly, educating yourself in depth about the possibilities and risks of leverage across different market, and always maintaining a cool, disciplined approach in every aspect of your trading decisions.
Using Maximum Leverage by Default
When broker platforms offer maximum leverage, traders should always consider what level they feel comfortable with and adjust accordingly. Just because maximum leverage is available does not mean it needs to be utilised.
While more advanced traders may have the skills, knowledge and experience to navigate positions with maximum leverage, beginner and medium level traders often benefit more from choosing leverage in line with the individual risk management plan and trading profile (as well as current market conditions).
Ignoring Volatility
Trading on the financial markets can be exciting especially during fast-moving periods but this can sometimes lead to emotional, impulsive decision-making. It can be tempting for traders to overlook volatility and focus on potential profits but high volatility can lead to price swings and put your leveraged positions at risk.
Best risk management practice is to monitor the markets and adjust position size and leverage during periods of high volatility.
Stacking Correlated Positions
When a trader opens multiple trades that move in the same direction (correlated trades), this can greatly increase risk as correlated assets usually react in the same manner to market events. This means losses can accumulate very quickly should the market move against your correlated positions.
Relying on Leverage to Recover Losses
Relying on leverage to recover losses is an emotion-led trading error where traders use borrowed funds to try to earn back money lost in previous trades. This is extremely risky because leverage will always magnify losses, which means traders could get caught in a cycle of loss and risk depleting their portfolio entirely.
Managing Leverage Risk – FAQs
What is a stock market leverage risk spike?
A stock market leverage risk spike refers to a sudden, unexpected increase in risk caused by high levels of leverage when stock prices move sharply or liquidity drops. This typically takes place during or after key market events such as earnings releases or geopolitical instability.
Leveraged stock positions are especially vulnerable to losses, margin calls or even forced liquidations after a spike, even when price drops seem minimal. This is especially evident in markets where many traders have taken out leveraged positions.
What is the primary leverage risk in trading?
While the key attraction of leverage is the opportunity to open large positions with small capital deposits, this also represents the greatest risk, where even a small market movement can trigger major losses.
Regardless of the market within which traders have taken out leveraged positions, the primary risk is great losses, magnified by the leverage itself. In the most extreme cases, such losses can exceed the initial investment, which is why stringent, tailored leverage trading risk management is so important.
What tools are available to control financial leverage risk?
Some of the most effective tools and strategies to protect leveraged positions include setting lower leverage, implementing stop-loss orders and guaranteed stops, and choosing position size carefully. These can all help to protect leveraged positions on the financial markets.
How can I choose a leverage trading platform?
First, choose a reliable, trusted broker with a good reputation that offers access to the highest-quality trading tools and software. Both MetaTrader and TradingView are primed to offer traders optimal conditions for trading using leverage.
Features to look for include fast execution speed, a range of advanced charting capabilities and analytical tools, strong security, competitive spreads and sophisticated risk management features. Responsive customer support and active trading communities to support traders as they advance on their journey will also prove invaluable.
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