Why do brokers offer leverage to retail traders, how do they benefit from it, and what’s in it for the traders?
This is probably something that you have asked yourself many times while leverage trading without knowing the true answer.
The main objective is of course to make money but exactly how do brokers make money on leverage?
There is more to this than just the increased revenue and I will provide some facts about why brokers let novice traders trade with more capital than they have ever used before.
It seems like a risky endeavor, however, many traders profit from using borrowed money thanks to strict risk-management systems and effective momentum trading strategies.
But why do brokers provide such high leverage ratios and what is the advantage of using these brokers compared to a regular platform that offers spot trading?
The short answer is that there are both benefits and drawbacks for both the broker and the trader using the leverage and if you read the entire article you will see how some traders make several thousands of dollars per day from active day trading.
Different types of brokers give leverage such as forex brokers, CFD brokers, or a crypto leverage trading exchange that offers leverage products.
All of these platforms have one thing in common, they want to make money as a business, and they all use different strategies to achieve this goal.
While some traders are easily fooled and lose their whole stake in just a few trades, others thrive from having more money at their hands and turn it into a money-making machine.
Leverage trading losses are normally bigger if you don’t use proper risk management tools.
If you are reading this article, you probably understand that brokers give leverage to traders to make money. While that is true there are two other subtle reasons that you probably haven’t thought about that are very relevant to most traders.
I want to take some time to explain the top three reasons why brokers offer leverage to both new and experienced traders and some of the advertising strategies that they use to attract more clients. In the end, the more clients a platform has, the more revenue it will generate.
Out of the three reasons listed below, the second and third reasons are very beneficial to most traders. These reasons usually go unnoticed and most negative comments are generally about trading platforms ripping off new traders through high leverage.
However, if you are smart and play your cards right you can make a lot of money by using a leveraged broker. In fact, without the added buying power and the way that these platforms are structured, you would probably not be able to trade some of the most famous currency pairs such as EUR/USD or GBP/JPY.
The same goes for all the American stocks that are offered by leveraged CFD platforms which are not available through regular stock exchanges.
The goal of any financial institution is always to earn revenue and make money. Without this objective, there would be no reason to start a business in the first place.
In the case of a leveraged broker, there are two primary ways they make money which I have listed below:
This holds for CFD platforms that offer leveraged contracts that mirror the price of the underlying asset. When you buy a stock on a CFD exchange you are not buying the underlying security, but instead, you buy the contract that the platform created.
By creating contracts that reflect the true price of a stock, CFD platforms can offer hundreds and even thousands of different exotic markets such as:
The list goes on and on. I could probably write 10 articles about the different markets offered by these platforms.
The contract mirrors the price of the real stock or the real value of the commodity with very good precision and it is not affected by liquidity issues as some ticker names experience during a year.
This is a huge advantage to traders who are searching for more markets to trade. All the markets I described above can be found on one single platform and that is another reason why they are so popular and not only for the amount of capital you can trade.
Without this advantage, there would be less activity in the order books, and the companies being these platforms would miss out on a lot of revenue.
Think about this the next time you visit a leveraged trading platform and use it to explore new markets and unknown tradable assets. Who knows, maybe you will find your perfect market out there.
Most beginner and retail traders do not have an account size of $25.000, instead, most novices start with less than $1000.
This put limits to what strategies and how many markets you can trade at any given point. Thankfully there is an option for all traders with insufficient funding.
Any investor who lacks a proper account size to make enough profits to stay in the game has the option to trade the same markets and more through a leveraged account.
If your initial investment is $800 you can now increase your position size with up to 100x leverage, or more if you are capable of handling the risks.
It is true that many new investors overleveraged themselves and blow up quickly but this is usually done with a smaller account size so the damage is not that big compared to losing an account size of over $10.000.
They say it takes a couple of blown-up accounts before you learn the true nature of how to trade the markets and if you are going to learn by doing, it better be with a smaller account.
Also, if you want to trade several markets at the same time while keeping your standard lot size, you need to use a leveraged account. It works like this because the difference between forex leverage and lots are two distinct things in trading.
While trading this small account you can add leverage to the mix and enter the markets with enough size to make real money on your positive trades. This is one of the biggest advantages of leveraging up and using borrowed funds.
If you are not already familiar with the concept of short-selling in a leveraged market I recommend that you read this article.
Short-selling is not traditionally an option on regular stock exchanges. However, through leveraged platforms, short-selling is a common practice.
With the use of leveraged contracts, you can easily borrow money, sell it to the market, and later buy it back when the price drops. This will yield a good profit if you are a talented speculator.
I will say that this style of trading is not for everyone and you need to be very comfortable about how to enter a negative market.
Many traders attempt to short-sell forex, crypto, or even stocks but fail miserably.
This is because, in reality, most markets go up more often than they go down. The reason for this is that there are more bulls in any given market and the bull markets are usually the most common trend.
However, it is an advantage to take notice of because the profits earned from a properly executed short position can outweigh your standard trades.
This is because when the market falls it triggers a domino effect and a negative feedback loop where traders get scared and sell their contracts only to trigger more fear in other traders and the cycle repeats.
Using an operator with leverage gives you the option to profit from downside movements as well.
Related: Use our short stock calculator to find out your profit, loss, and position size while shorting with leverage.
There are several types of platforms that offer increased buying power through borrowed funds and they all use the same system for lending out this capital to their traders.
Behind every broker, there is a liquidity provider (a large bank) that supplies capital to the traders of each broker. These liquidity providers are large financial institutions with bottomless pockets of cash that take the other side of most trades that you make on any platform.
The broker itself doesn’t take the other side of your trade, it only supplies the contract and the charting interface where you do all your active day trading. The actual capital that goes into the market comes directly from third-party institutions.
The process looks like this:
Keep in mind that with some platforms you can change the amount of margin you use and how much buying power you want to use for each trade. This way you can actively control your risk and plan your trades.
Use our leverage calculator to see your margin requirement while trading your market.
As mentioned there are different types of platforms that offer financing in different ways. They all work in the same way as described in the previous section with the only difference being the number of markets they offer, the amount of borrowed capital, and the products.
For example, through a forex platform, you can only access the forex market but through a CFD platform, you can access forex trading pairs as well as the most popular stocks and cryptocurrencies.
Which one you choose depends a little bit on the market you want to trade in and where you live. Not all geo’s have regulated platforms as an option and some traders have to choose off-shore brokers to find leverage.
Going with 1:2 leverage for beginners is usually somewhere around 1:2 – 1:10 but semi-advanced investors with at least two or three years in the game can go up to 1:50 in certain situations where the probabilities are highly skewed in their favor.
There are several advantages to choosing a broker that provides leveraged products and some of them have been explained earlier in this article. I want to shine some extra light on the most obvious reason, to amplify your profits.
This is a battle for many young and aspiring traders who struggle with a smaller account size. The fact that you can’t sustain your efforts as a trader with an account smaller than $10.000 is true and the less capital you have at your disposal, the more difficult it gets.
Most investors that I know that make good money from day trading or swing trading have an account size of at least $100.000 or more.
How they earned this money is another question but with a leverage broker, you can achieve the same results as a professional trader as long as you know how to trade the market and make profitable trades.
If you are in the early stages of your journey I would not recommend using a high ratio straight out of the gate. Instead, practice at lower ratios until. you have found what works for you.
Then, once you are capable of generating a profitable track record month after month you can start increasing the buying power slowly. I recommend that you read our guide on leverage.trading tips to increase your knowledge and make your learning curve a little bit shorter.
The benefits your earn from using an operator with borrowed funding outweigh the downside in my opinion and it is definitely worth testing it.
As always, there are no rewards without risks so let’s run through the most prominent risk factors that these operators will add to your portfolio and overall strategy.
Below is a list of the most common risk of using a leveraged broker:
This article explains the three main reasons why brokers offer leverage to retail investors and how you can benefit from this opportunity. The main reason is of course to increase profits by having investors pay more commissions through their brokerage. There are two more subtle reasons that you have probably not heard about which I will discuss in this guide.
The risk increases with a larger position size.
If you can find a sweet spot between overleveraging, and calculating your risk, in combination with a profitable strategy, you stand to make good money with these types of brokers.
