Are you considering becoming an investor? Well, it is high time you learned various investment terms. The terms will give a clear setup of how to trade in the markets. After that, you can strategise and make informed decisions about your investment. These key investment terminologies include margin and leverage. In this guide, we will give you in-depth coverage about them so that you can take full advantage of their benefits.
Before going full-throttle on the two terms, let us give you a preview of what they are in a simple language. The two terms refer to mechanisms of opening trading positions via a broker by investing a negligible amount of capital intending to take a larger position. In most cases, the two are used interchangeably. They can sometimes confuse newbies or even experienced investors and that is why we have tailored this guide to help you.
Margin: is a process of how you can increase your purchasing or buying power. It will mostly benefit you if your budget is modest. However, the increase in profit comes with high risk.
Leverage: is a mechanism of trading where you can increase your exposure to the market by paying less that the total investment. Better still, we can describe it as a way of taking a greater trading position without investing the full amount. After giving you that brief introduction, let us go straight to our table contents.
What is Leverage?
What is Margin?
How Does Leverage Work?
Which Instruments Can I Apply Leverage To?
What Can I Do to Minimise Risk When Trading with Leverage?
What is Leverage?
In the simplest language, leverage means taking full advantage of something. Within the financial circles, it almost refers to a similar scenario because it means taking advantage of your available funds using leverage to maximise the trading potential. However, we can still define it further to say that it is taking a negligible amount of funds and increasing its value in the investment space. To drive the point home, the example below will serve you better.
Let us use you as an example. Assume you have $1,000 as your initial capital and you want to optimise your earning potential. What do you do? You go to a broker who offers you a leverage of 25:1. This means you can place a position amounting to $25.000 by only depositing the $1,000.
A word of caution: leverage resembles the double-edged sword in that, in as much you reap maximum returns, you can as well reap big losses if the trade goes otherwise.
What is Margin?
Earlier, we talked of both leverage and margin being used interchangeably, which is true. However, there is a slight difference between the two. Here is where the difference comes in: margin is the number of funds required to place a position, whereas leverage is the catalyst or exposure for the outcome. To calculate your margin, think about your position size then divide by a high number. You can use a margin calculator; however, it is easy to calculate in your head. We will still use the example we used earlier.
For the leverage of $25,000 (25:1) that our online trading broker offered to calculate the margin, this is how to go about it. $25,000 divided by $25 (leverage) coming to $1,000 as the margin or minimum deposit required.
If the leverage was 10:1, we would calculate the margin as below:
$25,000 divide by $5 coming to $5,000 (margin).
The amount of margin required depends on various factors, such as the market, the risk involved, and the type of asset. Now, how do margin and leverage relate? Despite our earlier exposition on this issue, let us expand on it further. We can say that margin is a unique type of leverage, where you can use existing securities or cash positions as security or collateral. Its purpose is to increase your buying power. Where you have incurred too much risk, the lender or broker can put a margin call or a stop-out. What does stop-out and margin call mean?
Stop-out: it is where your equity equals half of the margin needed. If you have open trading positions without equity to cover them, the broker or trading platform closes them automatically.
Margin call: it happens when your balance, unrealised profit, and loss equal the margin requirement. With this, your broker will tell you to add more funds to bring your account to the minimum requirement.
How does leverage work?
Some traders start small and increase their leverage allowance as they get more experience and exposure. Even if your leverage is big, use the one that you are comfortable losing in case it goes contrary to your expectations. Doing this also allows you to keep your trading positions open until their maturity even when the result is negative. Another critical aspect is that leveraging is generally considered best when applied to short-term price projections.
The two terms you should know about leverage: Leverage buyout and stop-loss.
What is Buyout? It happens when a firm acquires another firm using borrowed money. Here, the firm is securing a larger trading position.
Stop-Loss: this tool comes into play to minimise the trading risks. It qualifies you to close the trading position automatically once you lose a set amount.
Which Instruments Can I Apply Leverage To?
We can use leverage in acquiring various trading instruments, such as ETFs, indices, stocks, currencies, and commodities. However, each instrument has its own leverage limit.
Leverage in forex trading: Leveraging in forex is not new. You borrow funds from a broker to trade in larger currency positions. If the trade goes as expected, you stand to reap the returns from the position – however, if it doesn’t, you’ll take a hit from the loss. Forex market experiences a daily currency exchange turnover of $5 trillion. You can use leverage in your forex trading to enhance your potential profitability. The sector offers a higher amount of leverage to traders or investors. To qualify for leverage, an investor is required to deposit a certain percentage of funds in their account, otherwise known as the initial margin. The margin required varies from broker to broker and depends on the trade size. Some common leverage ratios are:
50:1—2% (margin)
100:1—1% (margin)
200:1– .5% (margin)
As you can see from the above figures, the higher the leverage, the lower the margin. However, the currency being used can require higher margins. This is mostly based on the volatility of the currency pair, i.e. GBP/JPY. The more the wild large swings, the higher the broker might request for a higher margin rate, i.e. it can go as high as 5%.
Leverage on trading di commodity: the margin for commodities is low compared to the margin in stocks. This means both loss and profit potential are very high. For trading future, the margin is also lower than that of stocks. The futures account balance is always done at the end of each trading session.
Leverage on shares: When trading in the stock market, you can also borrow shares from a specific stock through your broker. As with other leverages, there are many risks involved. To tame the risks, you can employ various risk management strategies.
What Can I Do to Minimise Risk When Trading with Leverage?
Leverage carries both pros and cons. It can have abrupt upsides and downsides. In a clearer picture, there could be increased profit or losses depending on how the trade behaves. It is therefore very important to have a proper risk management strategy or plan. Not only that, adhere and follow it to the letter. There are many ways to reduce the risk.
The first and very critical one is planning to trade, and trading the plan. After that, choose the broker carefully and wisely. What to look for in a good broker?
The legitimacy and the rating in the brokerage space. There are many scams out there, therefore it is key to do thorough research on the status of the broker you intend to use. Are they registered, regulated, with excellent reviews, or trusted brand by other investors? You can do this through researching online, asking fellow investors or past users.
Another key aspect is whether the brokerage firm has 24/7 customer support and a technical team. You do not need a broker who takes all the time to return to you. What if it was an emergency that needed fast and actionable attention? How do you contact them? Do they have a working email, phone, contact form, or another contact mechanism that is fast, simple, and always reachable?
What are the layout, design, and tools? The way the platform is designed, is it user-friendly and simple to navigate through? Are the tools simple, locatable, effective, and usable? Are they up to date and enough to assist without having to seek help elsewhere?
What about the charges? Are they competitive, reasonable, and straightforward? Some brokers will give charges, with other hidden fees that render the brokerage services too expensive. Are the leverages tailored to favour you or the broker?
Finally, are there enough educational and market research resources? Does the broker offer quality research materials that can assist you in your trading? Are there free lessons or demo accounts for you to practice before going full swing into leverage trading? Are the resources free or do you have to pay some fee to access them?
Accessibility is another very important factor to consider. How do you access the platform? Is the platform compatible with mobile apps, laptops, or other simple electronic devices? It is equally important to consider the spread that the broker offers. Are they reasonable and profit friendly?
Finally, any broker that does not offer security to its customers is not worth the try. You cannot afford to lose your hard-earned capital within a splash. To avoid this, go through the feedback section, rating, and the security disclaimer to understand how they deal with emerging security threats.
There are more things to consider, however, equipped with the above you are ready to go. However, it is very important to have the tools below to limit damage or risk.
Take profit order: closes trades after the losses reach a certain limit. You can place it on the trending prices of either support or resistance.
Stop losses: closes your positions once it reaches a predetermined value. The stop-loss should be adjustable as per the market volatility.
Negative balance protection: some brokers provide negative balance protection. The purpose is to safeguard against unforeseen market conditions.
To avoid or limit meaningless price fluctuations for the most volatile assets, apply long-term averages.
Always invest in the amount you are comfortable in losing by following the 1% golden rule when investing in a single asset.
Portfolio diversification is another key tool. Always invest across various market segments, such as capital market, forex market, commodity market, and others.
Our final thought, leverage or margin trading, is like a double-edged sword that cuts across indiscriminately. The sword spares nobody, including the owner, as it goes back and forth both ways. Always be accountable for all your trading decisions and avoid being emotional. Apply all risk management tools at your disposal to trade with minimal risks. You can use each tool individually or combine them for better performance.
DISCLAIMER: Queste informazioni non vanno considerate pareri o raccomandazioni di investimento, ma comunicazioni di marketing
