Investors who engage in leveraged trading purchase assets that cost more than they can afford in cash. They deposit cash in a trading account, which acts as collateral against which they can borrow money from the broker to complete the trades. This type of trading is also called trading on the margin.
Leveraged trading is done from special accounts designed to allow the trader to borrow funds from the broker to conduct trades. Opening an account requires the trader to certify that he understands the risks involved in margin trading and that he agrees to adhere to the regulations on trading set by regulatory agencies and the broker. These regulations include specifications on the minimum amount of cash, or the minimum margin, the trader must maintain in the account.
As long as the trader maintains the minimum balance in his account, he can engage in trades up to the maximum leveraged amount his deposit allows. When a trader exceeds his trading limits, his assets are liquidated until his account holds the minimum margin. If he exceeds federal trading limits, then he may be subject to a federal call. Multiple instances may result in the freezing of his account.
The purpose of leveraged trading is to allow traders to engage in trades that would otherwise be out of reach. Markets have minimum purchase requirements that put them out of the reach of some investors. For example, the foreign exchange market requires a minimum purchase of 100,000 units of the base currency of the exchange. Leveraged trading allows individual investors without a large amount of capital to break into these markets.
There are, however, risks involved in leveraged trading. The movements of asset values are greater relative to the initial invested amount because the trader is not forced to put up the whole purchase price. If a trader is highly leveraged, a fall in the value of his assets may cause him to incur a loss of greater magnitude than his initial investment.
Different financial markets have different levels of allowable leverage. Equity markets, like the stock market, allow the trader to purchase only twice the value of his account balance. The highest leverage is found in foreign exchange markets, where a trader may purchase assets worth as much as 20 times more than the cash that he has in his margin account. Financial regulators, like the Federal Reserve Board, set maximum leverage limits, but a broker may decide to limit his clients to more conservative positions. Individual traders may also set their accounts to trigger liquidation at lower levels than the maximums allowed by the broker.