Leverage vs Margins: Key Differences

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Leverage vs Margins

Many traders often misunderstand the practicalities, risks, rewards, and differences between margin and leverage. Yet, it is important to fully comprehend margin and leverage before committing money to financial markets. 

Today’s blog post aims to highlight the critical differences between leverage and margin with regard to stock and forex trading

What is Leverage?

Generally speaking, leverage is a tool that allows retail traders to take on a position larger than their capital. In essence, leverage is the utilisation of borrowed funds to increase one’s trading position beyond what would be typically available from their cash balance alone. 

Brokerage accounts allow the employment of leverage through margin trading, enabling traders to profit from the full transaction size while committing a smaller amount of initial capital. 

How does leverage work?

In forex or CFD trading, leverage is designated as credit that a broker provides to a trader to increase the trader’s open position, and correspondingly amplify the trader’s profit and loss. Most brokerages offer leverage and it is easily accessible to retail traders who are looking to start trading.

The amount of leverage determines the largest possible position that a trader can take on. For instance, with a 1:100 leverage, a trader can conduct trade of $100,000 while only having $1000 of their own funds.

If the position profits by 2%, the trader will earn 2% of the full position size of $100,000, which translates to $2,000 with an initial capital of only $1,000. Conversely, if the position turns against the trader’s favour, losses would be amplified as well.

bullish and bearish
Image by Gerd Altmann from Pixabay

Leverage in Stock Trading vs Forex Trading

Forex trading comes with some of the highest leverage in the financial markets. Stock market leverage typically starts at around 5:1, while FX leverage can start from 20:1 depending on the jurisdiction. 

With the lower leverage offered, the risk of capital loss is lower in the stock market. However, forex traders with the experience to take advantage of the higher leverage ratio will be able to capture opportunities during volatile markets to take quick positions for higher profits.

What are the advantages and disadvantages of leverage?

The main advantage of employing leverage is to increase the purchasing power of the trader’s deposit.  Leverage allows many individuals with low capital the ability to trade in higher position sizes, allowing traders to earn income from assets they would not typically be able to afford without leverage. However, it is a double-edged sword because you can lose a substantial amount of money when the market moves against you too.

The usage of leverage comes with great risk and can be inherently dangerous as losses can be magnified. Traders employing leverage should be aware of the risks involved and implement appropriate risk management strategies accordingly.

What is a Margin?

A margin is basically a specified sum of money that a trader is required to put forward to place a trade and maintain a position. Typically, the margin isn’t a transaction cost, but instead, a good faith deposit that the broker holds while a trade is open.

The sum of margin required varies depending on the brokerage and is usually a percentage of the value of the proposed transaction.

How does margin trading work?

A margin account is used in margin trading, rather than the standard brokerage account. Margin refers to the amount of money available in the trader’s account, which is used as collateral for a loan to enable traders to purchase assets up to a specified multiple of the collateral they have provided. This limit is usually known as the margin requirement.

For instance, a retail trader who posts $1,000 of collateral with a margin requirement of 10% can purchase assets up to the value of $10,000. Margin accounts typically incur an interest charge to be paid on the borrowed funds.

It is important to note that sustaining losses could result in you falling below the margin requirement. Consequently, the investor would be required to provide additional funds in order to fulfil the margin requirements. Otherwise, their open positions will be closed out in order to maintain the margin requirements. This is referred to as a margin call.

It is important for traders to manage their positions and risks accordingly to minimize margin calls and unexpected exit of trades.  

managing positions and risks
Image by Gerd Altmann from Pixabay

Differences between Leverage and Margins

Although interconnected, the terms leverage and margins refer to two distinct concepts. Leverage is expressed as a ratio between the money a trader has, and the amount of money he can trade. The margin is thus the derived percentage of the deposit, based on the leverage ratio, required to be put up as an initial deposit.

Calculating Margin and Leverage

Leverage typically is calculated employing the formula below:

Leverage = 1 / Margin Requirement

Consider this example,

If the leverage is 100:1, this would mean that a $1,000 deposit can take a position of up to $100,000. The margin requirement is thus 1%. Similarly, if the margin requirement is 2%, the leverage will be 50:1.

Conversely, by utilising leverage, you can obtain the margin requirement as well.

Margin Requirement = 1 / Leverage

Conclusion

In summary, we established that leverage is essentially a multiplier offered by the broker where an initial amount in the account can be used to take up a much larger position.. When a trader opens a position or trade, a  minimum “margin” will need to be deposited in their account as collateral while the trade is open. 

As has also been noted, the core benefit of a retail trader employing margin is the ability to leverage on a lower initial capital to take on a larger position, thus enhancing their returns.  

Lastly, beginner traders should be careful when employing leverage in their trading, as profits and losses are amplified. It is necessary to have a good understanding of your risk tolerance and investment objectives before engaging in margin trading or using any other forms of leverage.

Contact us at Ortega Capital for more information.

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