Leverage: how does it actually work? The complete guide

Margin, margin calls, liquidation and borrowing costs: how leverage works in trading and how to use it without getting burned.

About Neverless

Neverless is a platform licensed under MiCA and MiFID II that lets you invest in stocks, ETFs, crypto, gold and silver with zero commission and at the best execution price on the market. Founded by three former Revolut executives, it already has more than 100,000 investors.

In March 2021, the family office Archegos Capital Management collapsed within a few days. It held concentrated positions in a handful of stocks, largely financed with borrowed money through derivatives. When those shares fell, banks issued margin calls that Archegos could not meet, then dumped the positions in a fire sale. Credit Suisse reported a loss of around $5.5 billion, Nomura close to $2.9 billion.

Yet leverage is not reserved for hedge funds: it is the same mechanism as a mortgage, applied to financial markets. Here is how it works, what it costs and how to use it without getting caught out.

Leverage: the 2-minute refresher

How a leveraged position works

Let's take a simple example. You have €1,000 and you think a stock trading at €100 will rise.

Without leverage (1x), you buy 10 shares. If the stock goes to €110, you make €100, or +10%.

With 5x leverage, you use your €1,000 as collateral and borrow €4,000: you buy 50 shares, for an exposure of €5,000. If the stock goes to €110, your position is worth €5,500. You repay the €4,000 borrowed and you are left with €1,500: a gain of €500, or +50% on your capital.

The mechanism works exactly the same way in the other direction:

Example excluding fees and interest, for a €1,000 stake.

The rule is simple: the change in your capital equals the change in the asset multiplied by the leverage. And the drop that wipes out your stake is roughly 100% divided by the leverage.

In practice, the platform closes the position before that threshold, as soon as the remaining margin falls below the maintenance level.

Margin calls and liquidation: what happens when the market falls

When the position loses value, the loss is charged to your margin first. The borrowed amount does not change. Your share of the position therefore shrinks faster than the position itself.

Back to the 5x example. If the stock falls 15%, the position is worth €4,250. Once the €4,000 loan is deducted, you have only €250 of margin left out of €1,000. The platform can then:

• ask you to add funds (margin call);
• automatically reduce or close all or part of the position (liquidation).

Liquidation often happens at the worst possible moment, after a sharp drop, and turns a paper loss into a realised one. Even if the stock bounces back afterwards, the position no longer exists.

In Europe, ESMA's rules on CFDs sold to retail clients have required since 2018 that positions be closed when margin falls to 50% of the minimum required, along with negative balance protection: you cannot lose more than the funds deposited in that account.

What leverage costs

Borrowing interest. The borrowed money is not free. Depending on the platform and product, you pay an annual interest rate, often calculated and charged daily. The longer the position stays open, the more this cost weighs.

Derivative financing fees. On CFDs or crypto perpetual contracts, a daily financing charge (overnight or funding rate) applies. It can be positive or negative depending on the direction of the position and market conditions.

Transaction fees. With 5x leverage, any fee calculated as a percentage of the order size weighs five times more heavily on your capital. A 0.5% commission on the exposure amounts to 2.5% of your stake.

Leveraged ETF decay. Daily leveraged ETFs (2x, 3x) rebalance every day. In a market that swings without a clear trend, their performance over several weeks can drift far from 2 or 3 times the index performance.

Example: an index goes +10% then -10%. It ends at -1%. A 3x ETF goes +30% then -30% and ends at -9%.

Leverage limits in Europe

For CFDs sold to retail clients, ESMA and then national regulators such as France's AMF set leverage caps by asset class:

These caps do not apply to every product, but they give a good sense of scale: the more volatile an asset, the lower the reasonable leverage.

Regulators also require CFD providers to disclose the share of their retail clients who lose money. Depending on the platform, it is most often between 70% and 90%.

Why use leverage

To amplify a conviction. This is the best-known use, and the riskiest. It only works if the conviction is right and the timing is too.

To tie up less capital. With 2x leverage, you get the same exposure while committing half the funds. The rest can stay available, or keep working elsewhere.

To hedge. An investor can open a short position with moderate leverage to protect a portfolio without selling their holdings.

To borrow without selling. Using your portfolio as collateral lets you raise cash without selling your positions, on the same principle as a Lombard loan.

Real case: Archegos, March 2021

Archegos Capital Management managed the personal fortune of its founder, Bill Hwang. The fund used total return swaps with several banks, which allowed it to hold very large positions in a few stocks, including ViacomCBS, without disclosing them like a regular investor.

In late March 2021, ViacomCBS announced a share offering and its price dropped. Losses on such concentrated and heavily borrowed positions triggered margin calls that Archegos could not cover. The banks then sold blocks of shares worth billions of dollars in a few sessions.

Two lessons

• Leverage turns an ordinary drop into a final outcome. Without borrowing, Archegos would have had a paper loss. With it, it was liquidated.
• Concentration combined with leverage is the most dangerous mix: one piece of bad news is enough.

Advantages of leverage

• It lets you take meaningful exposure with limited capital.
• It amplifies gains when your call is right.
• It frees up capital for other uses.
• It lets you hedge a portfolio or borrow without selling.

Drawbacks and risks

• Losses are amplified in the same proportion as gains.
• A moderate drop can be enough to liquidate the position.
• Borrowing costs eat into performance, especially over time.
• Psychological pressure pushes you into bad decisions at the wrong time.

Using leverage well: 5 simple rules

1. Think in exposure, not stake. A €5,000 position at 5x is a €5,000 position, not a €1,000 one.
2. Work out your liquidation level before opening the position. If the asset regularly drops 20% within a year, 5x leverage has no place there.
3. Favour low leverage. Between 1.5x and 2x, the safety margin stays comfortable.
4. Set a stop-loss. It gets you out at a level you choose rather than the one imposed by liquidation.
5. Never put at stake money you need. Leverage is a tool, not a shortcut.

Leverage, Lombard loan, leveraged ETF: three ways to borrow to invest

Why investors choose Neverless

Leverage you choose: up to 5x, which you can also leave at 1x.

Leverage backed by your whole portfolio: the loan is secured by all your assets rather than a single position, and the assets used as collateral keep earning yield.

Long and short in the same app: you can take positions on both rising and falling prices across stocks, ETFs, crypto, gold and silver.

No commission on orders: opening, reducing or closing a position carries no brokerage fees.

A regulated framework: Neverless is licensed under MiCA and MiFID II.

No platform makes leverage risk-free. What Neverless does is give you the tools to size it and monitor it.

Using leverage carries a high risk of capital loss, up to the full amount invested. This article is for educational purposes only and does not constitute investment advice.