What leverage is

The relationship the word describes 

Leverage is not an object. It is not a setting on a platform, not a facility that arrives from somewhere, and not an amount that can be counted on the panel beside the others. It is a comparison between two numbers the previous lessons already built: the full value of a contract, and the margin held against it. Wherever the first of those is larger than the second, the position is leveraged, and the word reports that fact and nothing more. Nothing has to be turned on for it to be true, and nothing can be turned off to make it untrue while the contract stays the size it is.

The relationship is fixed by the margin requirement, and by nothing else. The requirement is a percentage of the contract's value, so the value and the margin are the two ends of a single multiplication read in opposite directions. The smaller the percentage, the larger the contract that a given amount of margin sits under. A requirement of a tenth means a contract whose value is ten times the margin held against it. A requirement of a twentieth means twenty times. There is no second input and no discretion in it: the division is performed on two published quantities and produces one number.

That is why a margin requirement and a leverage figure are two readings of one thing rather than two separate facts about a position. The percentage form states how much of the contract's value has to be held. The multiple form states how large the contract is by comparison with what is held. This module uses the percentage form throughout, for two reasons that are practical rather than stylistic: it is the form the requirement is published in, and it is the form every calculation in the module actually performs. A multiple has to be converted back into a percentage before any arithmetic can be done with it.

What the calculation is performed on 

Everything in this lesson follows from one property of the contract, and that property was established before this module began. Profit and loss are calculated on the contract's full value. The margin held against it does not enter the calculation. It is not a coefficient in it, not a floor beneath it, not a cap above it, and not a term in it at all. The calculation is the price difference multiplied by the number of units, and neither of those quantities knows what was set aside.

A loss on a leveraged position is therefore calculated on a number larger than the margin held against it, so an adverse move produces a debit larger than the same percentage move would produce on a position the size of the margin, the debit can consume the whole of the margin, and losses are not limited to the amount deposited. A favourable move is the identical multiplication with the sign reversed and produces a credit of exactly the same size at the same distance. The two directions are symmetric in the arithmetic. They are not symmetric in the account, because the debit side reaches a point at which positions stop being the account holder's to keep open, and the credit side has no equivalent point.

Reading the pairs downward makes the mechanism visible. Each money figure is a percentage of the contract's value, and the margin appears in the block only as a thing the debit is being compared against after the fact. It plays no part in producing any of the figures. That is the whole of what leverage does to an account: it changes nothing about how the difference is calculated, and it changes how large the contract that the difference is calculated on happens to be.

The move that removes the margin 

One row in that block deserves isolating, because it is an identity rather than a coincidence of the numbers chosen. The margin held is the margin requirement percentage applied to the contract's value. A loss is a percentage move applied to the same contract's value. When those two percentages are equal, the two money amounts are equal, because they are the same percentage of the same number. The adverse move that removes the entire margin held against a position is therefore the margin requirement percentage itself. That holds whatever the percentage happens to be, on any instrument, in any account, with no exceptions and no rounding.

The identity runs in the direction that matters. A smaller requirement means a larger contract under the same margin, and it means a shorter adverse move removes that margin. Where the requirement is a tenth, an adverse move of a tenth in the contract's value removes the margin held. Where it is a fiftieth, an adverse move of a fiftieth does the same, and a fiftieth of a contract's value is a distance many instruments cover inside a single session. The favourable move of the same distance produces a credit of the same size, on the same arithmetic, and neither statement is a claim about which of the two is more likely to occur.

It does not follow that the position closes at that distance. What closes a position is the margin level test built earlier in this module, and that test compares the account's equity with the total margin used across every open position, not with the margin used by one of them. An account carrying free margin behind a position absorbs a running loss that has already passed the margin held against that position, and the position stays open. An account carrying little behind it reaches the close out condition sooner, on a shorter move, in the same instrument, under the identical requirement. The move that removes a position's own margin is arithmetic about the position. When an account stops carrying the position is arithmetic about the account.

Why losses are not limited to the amount deposited 

Nothing in the calculation stops at the margin, and nothing in it stops at the balance either. The contract carries on being priced for as long as it is open, the running difference carries on being restated, and the account's equity moves with it one for one. Equity can fall through the total margin used and continue past it, and it can continue past zero. The close out mechanism exists precisely because the arithmetic has no natural floor, and it is a rule applied to that arithmetic rather than a property of it.

Three mechanisms carry a loss past the amount deposited, and none of them is unusual or exotic.

• Price is not continuous. A close out is performed at a price the market makes available, and between one available price and the next there can be a distance. Markets that close and reopen, and scheduled announcements that reprice an instrument in a moment, are the ordinary cases in which the next available price sits some way from the last one.
• The test reads the account, not the position. Several open positions share one equity figure, so a loss on one is absorbed first by the margin free behind the others and then by the collateral supporting them, and the close out condition is reached on the total rather than on the position that produced the loss.
• Closing is an instruction, not a barrier. The rule states the level at which positions are closed. It does not state the price at which they close, and it cannot prevent the price from having travelled between the moment the level was reached and the moment a closing price was found.

A deficit can therefore exist after every position has been closed, and it is a debt rather than a paper figure. What happens to a balance in that state is not settled by the arithmetic and is not stated on this page: it is a matter of the documentation governing the account, and it is read there rather than inferred from the mechanism. What the mechanism itself provides is nothing. No floor, no cap, and no limit at the amount deposited.

A consequence of size, not a setting 

Two quantities determine the relationship a position carries, and only one of them is decided when the position opens. The margin requirement is published per instrument and applies to everyone trading that instrument on those terms. The size of the contract is chosen. The relationship between the two is what falls out of that choice, which is why leverage is better read as a description of a decision already taken than as a facility applied to an account.

The same point holds one level up. Requirements attach to contracts, but an account holds a quantity of money and a set of contracts at once, and the relationship between the total value of those contracts and the account's own equity is a different figure from the requirement on any single one of them. That account level figure is called effective leverage. It moves when a position is opened or closed, when equity moves for any reason including a running loss on something else, and when the price of an open contract moves, and none of those events involves a published requirement changing. The next lesson takes it in full.

Two accounts holding the same instrument under the same published requirement can carry entirely different account level relationships, because the sizes chosen differ. One account can change its own without any term changing anywhere, by opening a further contract or by watching its equity move. The published requirement is a constraint on a contract. The relationship an account is actually running is an outcome of what is in it.

Where practitioners disagree 

The first disagreement is about which figure deserves the name at all. One convention reserves it for the maximum a counterparty permits, on the grounds that it is a published term of the account and the only figure that is the same from one day to the next. Another points out that a maximum is a permission rather than a state, that an account can sit far below it indefinitely, and that every consequence described in this lesson attaches to the positions actually open rather than to the ceiling above them. The two figures can differ by a wide distance in the same account on the same day, which is why a bare leverage figure carries little information until it is clear which of the two is being reported. Reported figures are commonly the first. The arithmetic that closes positions reads the second.

The second is whether a margin requirement is a risk control. Regulators generally treat it as one, and there is a defensible mechanism behind that reading: a higher requirement means a given amount of money supports less contract value at once, which binds at the point where an account runs out of free margin. Practitioners who dispute it observe that a requirement does not choose a position's size, that an account with sufficient equity can hold an identical contract under either requirement, and that the requirement in that case changes only how much of the account is committed rather than how much market has been taken on. Neither side is misreading the mechanics. They are answering different questions, one about the maximum the arithmetic permits and one about the sizes traders take in practice, and there is no measurement that settles the second. What both accept is narrower and firmer than either claim: a requirement bounds an account, it does not bound a market, and the loss on a contract is calculated the same way whatever the requirement happened to be.