Margin and leverage: two peas in a pod
Margin and leverage are concepts that come into play when a trader wants more buying power than their current equity allows. In such cases, brokers offer a facility whereby traders are required to commit only a fraction of the cost of a trade. The amount that is committed by the trader is called Margin. This means you don’t need to pay the full value of the position you want to open. Instead, you pay a percentage of the position, which is also known as the initial margin.
The fraction that the trader needs to commit is predefined by the broker. This is expressed as a ratio and called Leverage. Let’s say the leverage defined by the broker is 10:1. This means you will need to commit 1 part in every 10 parts of the trade. In other words, you only pay 10% of the complete value of the trade to open the position.
How do margin and leverage work in trading?
To begin trading, you will need to make a deposit to your live trading account. The broker may have a minimum deposit requirement and need you to maintain a minimum amount in your trading account. This is known as the minimum margin or maintenance margin.
Example – You’re bullish about a rise in Apple’s share price. You want to open positions worth $100. With leverage of 10:1, you only commit $10 to initiate this trade. The broker will fund the remaining $90.
Let’s assume that the market does move in your favour and Apple’s share price rises by 2%. This means your trade makes a profit of 2% or $2. When the trade closes, you get $102. When this happens, you can return $90 to the broker and keep $2. Let’s consider this trade in terms of percentages.
Without using leverage: You would need to commit $100 to open the position. When Apple’s share price rises by 2%, you make a profit of $2. Here, you make $2 on an investment of $100. This translates to a 2% profit.
By using leverage: You would need to commit $10 to open the position. When Apple’s share price rises by 2%, you make a profit of $2. Here, you make $2 on an investment of $10. This translates to a profit of 20%.
What if you had $100?
You may be wondering whether traders with larger equity use leverage in trading. The answer is Yes. Even if a trader has the $100 needed to open the position on Apple, it doesn’t mean that they would put it all on one instrument, as traders usually aspire to diversify their portfolio. Hence, leverage would come in handy here to open more than one position.
Advantages & considerations involved with margin and leveraged trading
- Margin trading offers the opportunity to trade at higher volumes than traders could have with the existing capital in their trading account. To make such a trade, the trader will need to hold a minimum amount in the margin account to use this facility.
- Using leverage in trading substantially increases your potential profits from each trade. You can earn greater profits by putting in only a small amount of your equity in the trade. On the flip side, it also increases risk, so it would need to be considered as part of your overall strategy.
- Margin trading is familiar to intra-day traders. The intra-day market usually experiences steeper price movements that lead to more significant gains with leverage. But steeper price movements can lead to more considerable losses with leverage, so always consider this.
- With margin trading, traders can find opportunities with even the slightest price movements.
What is a margin call?
Traders need to maintain the minimum margin at all times. Let’s say a broker requires you to maintain a minimum margin of 5%, and you are about to place a trade of $100. This means you will need to have $5 in your margin account.
Now, you have deposited $10 in the account, and you begin trading. However, the market keeps moving against you, and you lose more than $5. This means your margin account is at risk of exceeding the minimum requirement. In such a scenario, the broker may notify you to deposit more money into your margin account to continue to trade. If you don’t deposit the money, your open positions will get automatically closed. This process is known as Margin Call.
How to manage risks while using margin and leverage?
As leverage increases both profit potential and risks, it becomes even more essential to adopt good risk management strategies.
- Plan the trade and trade the plan – It’s good to have a plan. You can create a strategy for trading using the demo account. It’s recommended to trade according to the strategy rather than making arbitrary decisions as prices fluctuate, and you should have alternatives planned.
- Keep learning – The more familiar you are with the trading platform, the instruments you are trading and the overall market movement, the better your decision-making will become.
- Set take profit and stop loss positions – By defining these positions with every trade, you may book profits when the market moves in your favour and curtail losses when the markets move against you.
- Use trailing stops on winning positions – This keeps increasing the price at which the stop loss is executed, which means that your potential for losses keeps declining as the market moves in your favour.
- Diversify your trading portfolio – Successful traders diversify their portfolios. This means you can open positions in instruments with a negative correlation (tend to move in the opposite direction) or no correlation (not impacted by the same set of factors).
Most popular instruments in margin and leverage trading
Margin and leverage can be used with almost every instrument. The next are amongst the most popular instruments offered:
- Forex: This is the biggest financial market in the world.
- Indices: Most popular indices include S&P500, Dow Jones, Nasdaq 100, FTSE 100, DAX 30 and CAC 40.
- Commodities: You can use margin and leverage to trade metals like gold and silver or commodities like WTI crude oil and natural gas.
- Share derivatives: Traders often choose margin-leveraged derivatives to gain exposure to the stock market. This is because these derivatives present opportunities in both rising and falling markets.
Margin and leverage can present opportunities to consider, which is the main reason for their popularity. Try trading with leverage on your demo account before live trading to improve performance before trading the live markets.
Disclaimer: Our content is intended to be used for informational purposes only. It is very important to do your own research before making any investment based on your own personal circumstances. You should take independent financial advice from a professional in connection with, or independently research and verify, any information that you find on this article and wish to rely upon, whether for the purpose of making an investment decision or otherwise. Klips does not put available shares or any other underlying asset, but CFD derivatives based in underlying assets.