What is leverage and margin in trading?

What is leverage and margin in trading?

Leverage and margin
Photo by @wanaktek

 

Leverage and margin are tools in trading that allow your money to go further than it could without it. Leverage is essentially a loan that allows you to buy more of an instrument. 

Therefore, having the opportunity to profit more from a single trade. However, while you can profit more, you can also lose the exact same amount.

This is why it’s is so important you understand how it works before you start trading on leverage. If you don’t then you could easily find yourself losing more than you would have expected.

Relationship between leverage and margin

Leverage and margin are similar and connected but they are not the same.

  • Leverage is when you take on debt or borrow from a broker
  • Margin is the money you need to put into the trade in order for you to receive leverage

You must have margin in order to get leverage.

Difference between leverage and margin

Leverage

Margin

Borrowed money that belongs to the broker

Your money

Allows you to take larger positions

Allows you to receive leverage from a broker

Expressed as a ratio

Margin requirement is expressed by a percentage

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How to calculate leverage ratio and margin requirements

Leverage is the ratio between how much money you have versus the amount of money you can actually trade (with the help of the borrowed money).

If you wanted to trade one standard lot of EUR/USD with no leverage, you would need $100,000 to take that trade. If you have leverage of 100:1, your margin requirement would be 1%, that means that you would only need to deposit $1,000 into your account in order to take that trade.

Below is a table to of examples of leverage and margin requirements, as you’ll see, it’s just maths.

Margin requirement

Leverage ratio

2%

50:1

3%

33:1

4%

25:1

5%

20:1

How to calculate leverage and margin requirement

  • Leverage = 1 / margin requirement
  • Margin requirement = 1 / leverage ratio

If the margin requirement is 2%, then the leverage is 50:1 because:

1 / 2 = 0.5

If the leverage is 25:1, then the margin requirement is 4% because:

1 / 0.25 = 4

Using leverage and margin in trading

When you’re trading and using leverage and margin, it is important that you understand that they allow you to take larger positions.

These large positions allow you to gain access to these markets and speculate on the price but large price movements can have a direct and immediate impact on your trading account.

If you want to buy a stock for $1,000 but you only have $200, then you can use leverage of 5:1 to help you take that position.

Once you have taken the trade, you will profit if the stock goes up and lose if the stock goes down.

However, if the stock goes below $800, you won’t have enough available margin to be in the trade, therefore your position will be closed. You will have lost your $200 and that’s it.

If the price then goes back up to $1,200, then you will not be in the trade and will have lost out on that profit.

Had you have had $500 and leverage of 2:1, you would still be in the trade (because the price did not go down to $500). And you would have profited from the price eventually going higher than you bought it.

Caution and fully understanding how leverage works is important. And ensuring you use it to your advantage. Missing out on profit like the above example isn’t ideal. In this scenario, you could take a smaller position which would mean that your original $200 would go further. Albeit, you would not see the same returns.

Trading on margin is different when it comes to trading forex versus stocks, we’ll go into more detail below.

Leverage
Creator: © Mark Evans

 

Using leverage and margin in forex trading

When you’re trading forex, especially through a retail broker, you’re not actually buying the currency, you’re speculating on the exchange rate between two currencies. It’s only the contract or agreement to buy or sell that is exchanged. Therefore borrowing is not needed.

The margin that is available to you is what you put into your account and what you must have in your account in order to open a position. This is because markets can move quickly and brokers try to protect themselves and you from your account going into the negative.

Using leverage and margin in stock trading

Trading stocks on leverage is more traditional because you are borrowing directly from the broker in order to purchase a stock. 

This is basically a loan from the broker, however, the broker never intends for this loan to be at risk because as soon as the market goes against the trader and approaches the minimum margin amount in the account, then they will close the trade. This is called a margin call. When you don’t have sufficient margin in your account to hold the position, therefore your positions are closed.

In this process, you do own the stock (until it falls below your margin level).

Leverage & Margin Summary

One of the key aspects you should take from this lesson is that there is risk associated with trading on leverage.

Using leverage and margin:

  • You increase the potential profits you can make
  • You increase the potential losses you can make

Therefore, be cautious when trading on leverage, especially if you have not done it before. We would recommend that you use a demo account before you get started. You’ll be able to play around with quantities to fully grasp how easy and hard it is to make and lose money.

You will also understand the difference between trading on leverage with stocks and with forex.

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