When you're investing in the stock market, it's essential to understand the concept of Leverage and Margin. These two terms can be confusing for new traders and investors, so we're going to break them down and explain how they work. We'll also give you some tips on using these concepts safely and protecting yourself from unnecessary losses. Let's get started.
What is Leverage in easy words?
For instance, let's say you have $100 but would like to increase your potential gains. You can ask your broker for Leverage. The exact leverage ratio varies but is usually 2, 5, 10, or 20. Imagine that the broker offers 20:1. With such a buster, you could manage a position of up to $2000 by placing a deposit of $100.
Leverage is a great tool if used correctly, but it can also amplify your losses if the market moves against you. That's why it's crucial to understand how Leverage works before using it.
Now that we know what Leverage is let's move on and talk about Margin trading.
Is Leverage and Margin the same?
So the difference between these two terms is that Leverage is a strategy, while Margin is the money you borrow to carry out this strategy.
When you're buying stocks on Margin, you're essentially borrowing money from your broker to purchase the shares. The good thing about Margin trading is that it allows you to buy more shares than you could if you were only using your own money.
The downside of margin trading is riskier than traditional investing because you're borrowing money to make your investments. If the stock market goes down, you'll not only lose money on the investment itself, but you'll also owe money to your broker.
Some brokers have a Margin calculator integrated into their websites. Still, you can do it yourself with a Margin formula as well.
For instance, the Margin ($250) = Total assets ($2500) / Leverage (10:1). In this example you have to cover a $250 margin (or 10% => 10:1).
Margin requirements can differ. It depends on asset types, risks, and markets.
Also good to know:
There are several nuances in using this strategy. If your risk is too high, you might be forced to close your position. Let's speak about two essential terms:
A margin call. It is a notification from your broker that you are required to deposit more money or securities into your account because the value of your margin loan has fallen below a certain level. If you get a margin call, your margin is close to being broken or broken (stock fell more than 10%).
The stop-out is when your broker automatically closes your position because the value of your margin loan has fallen below a minimum level.
How does it work? (Read carefully)
Now that we know the theory, let's check the Leverage and Margin in some examples.
The choice to use this strategy or not is up to you. And it is always essential to think about the risks. (Here, you can read our article about Risk Management for traders and investors). However, by choosing to use this technique, you can increase your buying power.
Pay attention to the broker's "Leverage Ratio." It is the ratio of your position's notional value to the amount of money you have deposited.
For example, suppose you have a Leverage Ratio of 30:1 and a Used Margin of $100. In that case, it means that you're able to trade $30 worth of currency for every dollar in your account.
If your broker requires a two percent margin, you would need $200 in your account to purchase $10000 worth of currency (10000/200 = 50). In this case, your Leverage Ratio would be 50:1.
Remember that Leverage can both help and hurt you. The broker allows you to take a higher position (amount of shares) in leverage trading by only depositing a small margin. The Margin can typically be as little as only 2% of the actual trade and as high as 80% of the trade. This allows you to have a massive exposure with relatively little investment.
However, stocks and options may swing fast, which can cause you to lose your position if you cannot cover the margin call that will come once you pass the margin limit for your trade. In the worst case, leveraged trading may cause you to owe a substantial amount of money.
An example to illustrate this can be a solid company like Target Corporation (NYSE: TGT). When Target posted its quarterly results in May 2022, before markets opened, the stock took a massive fall in the following trading. Investors got scared from the inflation warning posted with the results. If you were sitting with a leverage of 1 to 10, meaning you borrowed every 9$ dollar for the trade, your losses on the opening would be extreme as the stock fell more than 24%. Not only would all your capital be lost, but you would also owe the broker another 14% of the total amount.
To prevent it:
- Use Stop-Loss. This allows you to get out of trade automatically if it goes against you by a certain amount;
- Do not forget about "Take profit orders." It is an order to automatically close your position when it reaches a certain level of profit;
- Do not overuse Leverage! If you are a beginner, use lower ratios. And if you are a professional, do not use Leverage higher than 50. It can be too much risk;
- Check if your broker has a "Negative Balance Protection" feature. It means that your broker can help you not go red and save you from some losses. If this feature is available. Read the conditions very carefully;
- Do not take more than you can afford to lose.
Please note that Leverage and Margin trading can be extremely risky and is not suitable for everyone. Be sure to consult with a financial advisor before making any investment decisions.
Summary
Leverage and Margin are two important concepts to understand when trading in the stock market.
Leverage is a strategy that allows you to purchase more shares than you could if you were only using your own money. And Margin is the money you borrow to carry out this strategy.
The downside of margin trading is riskier than traditional investing because you're borrowing money to make your investments. If the stock market goes down, you'll not only lose money on the investment itself, but you'll also owe money to your broker.
The choice to use Leverage is up to you, but if you do, be sure to know all aspects of this strategy, calculate your risks, use stop-loss orders, and take-profit orders to protect yourself from losses.
We hope this article was helpful, and now you understand Leverage and Margin better. Good luck in your trading! And do not forget to follow our blog for more stock market-related articles.
