Margin and Leverage

Trading on margin is used to increase your trading power, in the sense that it allows you to put up only a fraction of the funds you would normally need in order to open a much larger position. This means rather than paying the full value of your position, you only need to pay a percentage of the position, which is called ‘initial margin’. While trading on margin can be beneficial, it is also high-risk, given the fact that you can potentially lose your entire investment.

What are margin and leverage?

Simply put, margin is the amount of money required to open a position, while leverage is the multiple of exposure to account equity. The amount of margin depends on the margin rate requirements. This differs between each trading instrument, depending on market volatility and liquidity in the underlying market.

Leverage is simply using borrowed money to fund your trades, while margin refers specifically to using borrowed money as capital to trade. Leverage allows you to make bigger trades in the financial markets than what you have capital for, which is why through the use of leverage, your trading profit or loss can potentially be much larger. This is because your trading results are calculated based on the total value of your borrowed positions.

What is a margin call?

Any time you trade on margin, you are also risking the possibility of a margin call. A margin call occurs when the required equity relative to the debt in your account has fallen below certain limits. A margin call is essentially both a warning and a request by your broker to bring the margin account’s balance up to the minimum maintenance margin requirement. To satisfy a margin call, you must either deposit additional funds or close current positions. You are also entitled to ignore the margin call, but you run a high risk of experiencing a stop-out and have your positions be automatically closed, if your margin falls below the stop-out level.

How can leverage magnify gains?

As we have already established, leverage works by using your deposit, known as margin, to provide you with increased exposure to an underlying asset. Your total exposure compared to your margin is known as the leverage ratio.

For example, let us assume you want to buy 100 stocks of a company with a current value of $150. With a leverage of 1:5, you can open a 100*$150=15,000 position by only using a margin of $15,000/5 = $3,000. So, with leverage you don’t need to have a big initial investment and you can enjoy bigger gains if your trades are profitable. For example, if you are correct in your prediction and your stock moves by $5 in your predicted direction, then your gains would also be multiplied by 5 times.

How can leverage magnify losses?

While the use of leverage can be profitable, if your trades are successful, the reverse is also true. Leverage magnifies gains as well as losses. This means that if your trade moves against you, losses are equally magnified and can deplete your margin. Going back to our stock trading example, if the stock price moved by $5 to the opposite direction than your trade, your available margin would drop by $5*5 = $25.

Example of Leverage

Let us assume that you would like to place a forex trade on the EUR/USD, using a maximum leverage of 1:30, which means that for every dollar you put up, you can trade $30. You deposit $1,000 as margin, which is the collateral or equity in your trading account. This implies that you can initially place a maximum trade of $1,000*30= 30,000 or 0.3 lots. However, using the entirety of your margin on one trade is too risky, so you decide to place only 0.1 lot or $10,000. You will therefore be using only $10,000/30= $333.33 of your total margin to place your trade. It is important to note, that you are still placing a $10,000 trade and if, for example, the trade moves against you by 10 pips, you will suffer a $10 loss ($1 per pip). The opposite will be true if the price moves in your favour.