Over-leverage occurs when a trader uses too much borrowed capital (leverage) compared to their own money (equity). While leverage can help increase profits, using it excessively makes a trader highly vulnerable to even small price changes. Over-leveraging can quickly result in large losses, margin calls, and the liquidation of a trader’s account.
Leverage allows traders to control a large position with a smaller amount of their own money. However, if the market moves against the trader, the losses can exceed their initial investment, potentially leading to a margin call (requiring more funds) or the closing of the trade to prevent further loss.
Let's say a trader has $1,000 in their account and uses a 100:1 leverage ratio for a stock trade. This means they can control a position worth $100,000 (100 times their capital).
Total Position Size: $1,000 (trader’s capital) × 100 (leverage) = $100,000
The stock price goes up by 1%, so the position value increases to $101,000.
Profit = $101,000 - $100,000 = $1,000.
This represents a 100% return on their initial $1,000 investment.
The stock price drops by 1%, so the position value falls to $99,000.
Loss = $100,000 - $99,000 = $1,000.
This 1% loss wipes out the trader’s entire initial $1,000 capital.
In this case, the broker would likely issue a margin call for more funds to keep the position open. If the trader cannot meet the margin call, the broker would close the position, liquidating the account.
Over-leveraging can turn a small market movement into a large financial loss. Even a small price change can result in the complete loss of the trader’s capital. While leverage increases potential profits, it also significantly increases the risk of large losses. This is why it’s crucial to use leverage carefully and to always ensure that position sizes are manageable relative to the trader's capital.