Leverage and Margin Explained for Beginners

Imagine you want to buy a new bicycle that costs $500. You have $100 in your pocket, but you don’t want to wait until you save up the full amount. So, you ask a friend to lend you the remaining $400. If you use this approach, you are essentially using someone else’s money to increase your purchasing power. This, in a very basic sense, mirrors what leverage and margin do in the world of investing; they help you control a larger investment with a smaller initial amount.

What is Leverage?

In financial terms, leverage is like using borrowed money to amplify the potential return of an investment. It’s akin to using a lever to lift a heavy object – you use less effort to achieve a greater result. In investing, leverage allows you to control a larger position (asset) than the amount of capital you initially invest. This can greatly increase your gains if your investments are successful, but it also magnifies your losses if the market goes against you.

For example, if you have $1,000 and use a leverage of 10:1 (also written as 10x), you can control $10,000 worth of assets. This means that you could potentially gain or lose ten times more than you would have by simply investing your $1,000 directly. A common way leverage is used is through derivative instruments, like futures or options contracts.

What is Margin?

Margin is the initial amount of money you need to put up as a good faith deposit when you use leverage. In essence, margin is your portion of the total investment, with the broker providing the rest through leverage. It’s like a down payment on a house when you get a mortgage; it’s the part that you put up front, representing your commitment to the deal.

Think of it like this: if you want to control $10,000 with 10:1 leverage, your margin (your initial investment) would be at least $1,000. The remaining $9,000 is essentially borrowed or provided as the leverage from your broker. The margin’s role ensures that trades where leverage is used can proceed; it acts like a financial safety blanket for the lender.

How Leverage and Margin Work Together

Leverage and margin are two sides of the same coin. Leverage allows you to control larger positions, and margin is the cash you need to hold in your account to do so. Different brokers will have different margin requirements. Let’s explore how this can play out in a real investment scenario.

Imagine you believe the price of gold will rise and decide to trade gold via your broker. Let’s say your broker offers a leverage of 20:1 or 20x. If you deposit $500 into your trading account, you could control $10,000 in gold positions – your $500 initial margin gives you control of twenty times that amount. If the value of gold increases by 10%, your $10,000 position would gain $1000. Since your initial margin was only 500, a $1000 gain means you have effectively doubled your initial investment.

However, consider if gold decreased by 10% with that same position. Then you would have lost $1000. With only an initial investment of $500, you would not only lose the full amount but you’d be out more than what you invested.

This illustrates the power, and the danger, of margin and leverage. High leverage can make small price changes into massive profit or loss impacts.

Different Leverage Ratios

Leverage is often expressed as a ratio, such as 2:1, 5:1, or even 100:1. A higher leverage ratio allows you to control a much larger amount of assets with a small initial margin, but also exposes you to potentially greater losses. A 10:1 leverage ratio means for every $1 you deposit as margin, you control $10 in the market. The specific leverage ratio that is provided will differ by instrument and the broker you are using. Higher leverage typically comes with more risks so they are often restricted to more experienced traders.

  • 2:1 Leverage: For every dollar you put up as margin, you control two dollars in an asset
  • 5:1 Leverage: For every dollar you put up as margin, you control five dollars in an asset
  • 10:1 Leverage: For every dollar you put up as margin, you control ten dollars in an asset

It’s important to understand that these ratios are not standardized across all brokers or asset classes, so always confirm the leverage provided. Leveraged trading is not a standardized product, different brokers will have different offerings and margin requirements, especially related to different markets.

The Risks of Leverage and Margin

While leverage can magnify profits, it’s vital to know that it also magnifies losses. A small unfavorable movement in the market can have a large impact on your account balance. Since losses can exceed your initial margin, you can end up owing your broker money if you are not careful. Additionally, your broker can initiate a ‘margin call’ which is demand for you to provide more funds to your account to cover the losses incurred. Failing to meet these calls can also result in them liquidating your position and closing trades, locking in potential lost funds. Understanding these risks is crucial before trading with leverage.

Another critical aspect to consider is the emotional toll that can be associated with leveraged trading. The potential swings in profits and losses can lead to anxiety and rash decision-making. It’s not uncommon for traders to get caught up chasing losses, resulting in even greater losses. When markets are volatile, the risks are especially elevated.

Who Should Use Leverage & Margin?

Leverage and margin are not for everyone. Due to the high risks and potential for large losses, they are generally better suited for more experienced traders who have a deep understanding of the market being traded, and who have a working knowledge of risk management techniques. Beginners should be especially cautious when starting out with leveraged instruments. Using leverage and margin responsibly is critical.

Tips for Trading With Leverage and Margin

  • Start Small: When you’re new to leverage, start with small positions. This will help you gain experience without risking too much capital.
  • Use Stop-Loss Orders: Utilize stop-loss orders to limit your potential losses on any trade. This ensures less unexpected risk when trading.
  • Educate Yourself: Do your homework. Deeply understand the workings of leverage and your chosen market before putting any real funds at risk.
  • Manage Your Risk: Never risk more than you can afford to lose. A general rule of thumb is less than 1-2% of your capital per trade. Risking everything on one trade is never a good strategy.
  • Do Not Chase Gains: Be prepared for trades to end in a loss which will happen. Emotional decision-making when chasing after prior losses will generally lead to further losses. Have a strategy and stick to it.

Conclusion

Leverage and margin can be powerful tools in the hand of a skilled trader. They can greatly increase profit potential, but come with significant risks of losses when the market moves unfavorably. For beginners, it is crucial to take the time to understand their workings, the risks involved and to develop appropriate risk management strategies before trading, while considering if leveraged strategies are right for their profile. This article provides a high level overview of leverage and margin, and should be seen as a starting to point before doing further research to fully grasp the details of this topic.

Frequently Asked Questions (FAQ)

Q: What happens if my losses exceed my margin?

A: If your losses exceed your margin, your broker may issue a margin call, requiring you to deposit additional funds to cover the deficit. If you fail to meet the margin call, the broker has the right to close the position, locking in further realized losses.
Q: Is leverage guaranteed?

A: No, brokers can change their leverage availability at any time. Leverage for certain instruments and in certain markets can change at different times.
Q: Can I lose more money than my initial investment when using leverage?

A: Yes, it’s possible. If your losses exceed the initial margin deposit, you may end up owing your broker additional funds.
Q: What is a margin call?

A: A margin call is a notification from your broker that your account is under-funded, and you are required to deposit more funds to bring it back up to par, due to losses in your leveraged trades.
Q: Is all leverage the same at different brokers?

A: No, different brokers have different risk tolerances and may offer different options and ratios. Always confirm what each broker provides.
Q: Can I use leverage with any assets?

A: No, the specific asset classes and instruments that can be traded with leverage will be broker dependent.

References

This information is intended for general educational purposes only. Always consult a financial advisor before making any investment decisions.

  • Investopedia. “Leverage.”
  • Investopedia. “Margin.”
  • Corporate Finance Institute. “Leverage.”
  • Corporate Finance Institute. “Margin.”

Are you ready to trade? Explore our Strategies here and start trading with us!