Why Do Brokers Offer Leverage To Retail Investors?
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 leverage 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.
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.
The 4 main reasons why brokers provide leverage
If you are reading this article, you probably understand that brokers give leverage to traders in order 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 actually 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.
To learn more, read our guides: What is high leverage trading and high leverage trading strategy?
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.
1. To make more money
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:
- Trade fees and commissions – Now, while a standard stock exchange also makes its money from trade commissions and trade fees, leveraged platforms use this revenue source to the max. For example, if you buy a stock on a regular exchange for $500, the exchange will make around $0.50 of profit. If you use the same amount of starting capital and use 1:50 leverage to buy the same stock on a CFD platform the broker will make $25. The reason for this is because your position size is 50 times bigger and therefore the fee you pay is 50 times more. This is extremely the main source of income for a leveraged broker.
- Overnight management fee – An overnight fee or a management fee is the second revenue source and this is a fee that is charged every night around midnight. This fee is an interest payment that you are obligated to pay to the platform for using the borrowed capital in your open position. The overnight fee only applies to positions that are held overnight. It is the same interest payment that you would pay for taking out a loan to buy a house or a car with the exception that this is a smaller amount and it is charged daily. Once you close out your position this fee stops.
2. To offer more markets
This holds true 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 the course of 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.
3. To enable traders with smaller accounts
Most beginner and retail traders do not have an account size of $25.000, instead, most novices start out with less than $1000.
This put limits to what strategies and how many markets you are able to trade at any given point. Thankfully there is an option for all traders with insufficient funding.
Any investor that lacks a proper account size to make enough profits to stay in the game have the option to trade the same markets and more through a leveraged account.
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.
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 definitely one of the biggest advantages of leveraging up and using borrowed funds.
4. To offer short-selling
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 in 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 triggered 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.
What is broker 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:
- A trader deposits money in the account as collateral.
- The trader chooses a market to trade.
- Selects the position size or lot size.
- Enters the market either short or long with his capital + the leverage capital.
- The leveraged capital enters the market together with your capital.
- The profit or loss is calculated on the total position size.
- When the trader closes out the position the margin capital is returned to the account.
- The leveraged capital is funneled back to the liquidity provider’s open bank account.
- The profit or loss is calculated and added or withdrawn from your margin capital.
Keep in mind that with some platforms you are able to 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.
Different types of brokers
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.
- Forex – Popular forex trading platforms such as Saxo Bank offer direct access to the international currency market, or FX market, where you can trade currency pairs such as CAD/JPY. For those who are only looking to trade national currencies this option is great because the biggest names in the industry are heavily regulated and supervised by the big watchdogs. The downside to choosing a pure fx broker is that you can’t access other markets. In the case of Saxo Bank you can and this is because it is an international bank.
- CFD – Platforms such as CMC Markets, XTB, and Pepperstone are famous CFD operators that offer several exotic markets such as shares, indices, ETFs, fx, and cryptocurrencies. These kinds of operators are also heavily regulated as long as you pick a popular name. I would stay away from brand new platforms that advertise high-yield strategies or deposit bonuses.
- Cryptocurrency exchanges – BitYard and Binance are two examples of great cryptocurrency exchanges that offer high leverage in the digital currency markets. Bityard is regulated in several jurisdictions while Binance is non-regulated but has a state-of-the-art reputation. These operators are good options if you are looking for leveraged accounts in the cryptocurrency markets
- Derivatives platforms – For those traders who depend on options or futures to make money should consider a derivatives operator. Options platforms are typically limited to a leverage ratio of 1:50 while futures exchanges offer higher ratios. Perpetual swaps are investment vehicles that beginners often use since they are not limited to an expiration date which makes them easier to handle.
The best leverage ratio 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.
Benefits to a leveraged broker
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 that 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 outweighs the downside in my opinion and it is definitely worth testing it.
All the common risks
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:
- Larger losses – To me, this is the biggest threat of them all and if you are not careful you can end up losing all your money in a matter of minutes simply by making one wrong decision without a stop-loss order. If you buy with a high ratio and the price drops immediately after you have entered you can suffer very large losses very quickly.
- Increased fees – If you leverage your position 30 times your fees will be 30 times bigger as well. This is something that most traders don’t know and they can spend several hundred dollars in one single day of trading without knowing it. Later when they check their trade history they see that each trade they made cost around $15 due to the high leverage used.
- Margin call – A margin call is a warning sign that you receive from your operator due to very large losses. This warning signal tells you that you are running out of cash and that you are in big trouble. If you ignore this warning sign you could end up with a liquidated account.
- Liquidation – Liquidation is a total loss of all trading capital due to large losses.
- Difficult to understand – Compared to regular spot trading, using leverage can be difficult to learn and understand. This is because you need to control several other factors such as your margin capital percentage, liquidation price, and knowing how to calculate your leverage. Read our guide on spot trading vs leverage trading to learn more about the differences.
- Overtrading – Greed often strikes new traders when they use a leveraged broker for the first time and this can lead to overtrading. Overtrading is irrational and usually results in unwanted losses.
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.
It goes without saying that the risk increases with a larger position size.
If you can find a sweet spot in between overleveraging, and calculating your risk, in combination with a profitable strategy, you stand to make good money with these types of brokers.