Leverage and margin in trading: Everything you need to know
Leverage and margin in trading: Everything you need to know
Whether you are a beginner or even a seasoned trader, you’re likely to come across the terms ‘leverage’ and ‘margin’ at some point. These concepts can be confusing, but you need to understand them in order to be confident when trading with certain products.
As well as offering up basic definitions, this guide will also outline the benefits and risks, regulatory limits, and the products that allow you to trade with leverage and margin.
What is leverage in trading?
In simple terms, leverage gives traders control over assets without having to cover the cost of the trade’s full value. This means they can place larger trades with smaller amounts of money in their trading account. The role the broker plays in this process is to effectively lend the trader the extra capital, multiplying the size of the trade.
The degree of leverage ratio varies from 10:1 to as high as 500:1 depending on the broker, regulations, and the financial asset. As noted by Investopedia: “Stock investors [in the US] are allowed to borrow up to 50% of the value of a position under Reg T, but some brokerage firms may impose more stringent requirements.”
Taking the example of forex currency trading, if a trader wants to buy a currency pair EUR/GBP (euro vs pound sterling) because they think the price of the euro is going to rise against the value of the pound, they could do so using a leveraged product.
In essence, this means they only need to make a small deposit to open this trade. So, when a product is leveraged, it increases its trading power. But it’s vitally important to appreciate that this increased trading power can magnify losses as well as profits.
What is the margin in trading?
The margin is the amount of money a trader needs to deposit in their account to make the trade. It is not an additional expense — just part of the balance or ‘account equity’. This is the minimum amount they will need in their account to initiate the trade.
If the leverage ratio is 10:1, a trader would only need to put down 10% of the total trade value. So, for a £1,000 trade, they would have to meet the £100 margin requirement to place it. Although this sounds pretty straightforward in theory, it can be tricky to calculate the margin in practice as there are so many other figures involved (like the buy and sell prices, and the amount being traded per point).
As a beginner, it may be helpful to run through a few practice trades to make sure you’re comfortable with leverage and margins before you risk your own money. A resource that can help you with this is Trade Nation’s trading simulator, a free to use and risk-free tool that guides you through the process of making a trade step-by-step. You can use it to see how different trades impact the margin requirement.
How do you trade with leverage and margin?
Leveraged products allow you to trade across a range of markets, such as forex, stock indices, shares and commodities. There are two primary ways to do this:
Spread trading
Spread trading is one of the most common leveraged products. The trader deposits the margin requirement, which is a small percentage of the total value of the trade and will buy if they believe the price of the market is going to rise or sell if they believe it is going to fall. An accurate prediction means they will profit, but equally, they will experience losses if the market goes the opposite way.
At the beginning of the trade, there is a buy and sell price for the market in question. The ‘spread’ refers to the difference between the two prices. This reflects how much it costs to make the trade — the bigger the spread, the more costly it will be.
The spread can be fixed or variable. Fixed spreads do not increase when the market becomes more volatile, whereas variable spreads will change according to fluctuations in the market. An increase in volatility means spreads will widen, along with the trading costs.
CFD trading
Like spread trading, contract for difference (CFD) trading involves speculating on the price movements of a market. The difference with CFDs is that the currency you are trading in depends on the specific market.
A trader ordinarily using GBP may need to make a CFD trade in USD, and therefore must consider how this could influence their potential profits or losses, as well as additional costs such as currency conversions. Spread trading, however, allows the trader preference over the currency they are trading in.
In addition, unlike with spread trading, CFD brokers may impose certain restrictions on the trade size, or amount per point, giving traders less control over the amount they trade.
Risks and rewards of trading with leverage and margin
The trader has the opportunity to gain profits that are significantly magnified compared to the money they have deposited. For example, leverage at 10:1 means potential returns will be 10 times greater compared to a non-leveraged equivalent. What’s more, because the trader is only required to pledge a fraction of the value of the assets being traded, this increases the possibilities when it comes to how they use their capital. Leverage and margin mean they can spread the money they have across more products and markets if they want to.
However, markets won’t always move in the way a trader anticipates. And when this happens while trading a leveraged product, that means their losses are multiplied, so they run the risk of magnifying the amount they lose.
This is especially important to bear in mind when trading volatile markets such as forex, where prices can move sharply. It is, therefore, essential that traders make sure they comprehend the risks and only trade with money they can afford to lose. Understanding their specific market is also vital before they increase their investments in leveraged products.
