Leverage and Margin

Margin and leverage are tightly related, but they are not the same thing. Margin is used to create leverage. When you use margin, you create leverage and get additional trading power. Because of leverage traders are able to hold positions that are larger than the amount of capital in their account would otherwise allow. So, margin and leverage do talk about the same concept, but from different perspectives.

What is Leverage?

Leverage is using borrowed capital to increase the size of a position, thereby expanding the potential for gains or losses in that position. Leverage also allows a trader to open more positions with their available capital, thereby diversifying their account. CFD leverage can be as large as 400:1 or as little as 2:1. Often the amount of leverage available depends on the asset being traded. One thing to keep in mind is that leverage always increases risk. It is a two-edged sword because in addition to increasing the potential gains in any trade, it also increases the potential losses.

What is Margin?

Margin is used to create leverage by borrowing from a broker to open positions that are larger than the trader’s available capital would otherwise allow. For example, if you wanted to buy 100 shares of Tesla at $900 per share you would need $90,000. However, if you have a broker that is willing to allow you to trade with margin, you might be able to open the same position with just 5% of the required capital or $4,500. That leaves the trader with additional capital that can be used to open other positions.

What are the Benefits?

The use of margin and leverage does increase risk, but they also come with a number of benefits for the traders that use them properly. For one thing, margin allows your capital to go much further than it could otherwise, which can provide diversification benefits. The use of leverage introduces the possibility of increasing the rate of return on any trades. Margin also provides a trader with helpful financing for trades. Because the use of margin is typically pre-approved at the account level, as long as the trader holds the required margin amount in their account they are able to continue borrowing without the need for more paperwork, or renegotiating financing terms. Interest rates on margined funds are usually quite competitive as well.

What are the Risks?

While margin and leverage create some very appealing benefits, after all who can resist increasing their rate of return on a trade by 400 times? But they are certainly not without risks. For one thing, that 400x trade could just as easily magnify a loss by 400 times just like a winning trade. So, the worst risk of margin and leverage is also its strongest benefit. Another risk in leveraged trading that often isn’t considered by beginners is the risk of losing money due to overnight interest charges. Margin costs are calculated overnight, so every night that a position is held open incurs additional financing charges. These seem small individually, but they can certainly add up over time. Also, when using a broker without negative balance protection, leverage makes it possible to suffer a loss that’s greater than the balance held in an account. This will require the deposit of additional funds that the trader might not have been planning on using in the market.