One of the secrets to wealth is the use of leverage. In short, the principle of leverage, as applied to making money, is to use a small amount of money to control a large asset.
Here, you explore leverage and how it relates to and differs from the margin made available to you by your brokerage firm.
Leverage: A double-edged sword in the battle for wealth
A common example of using leverage is when you buy real estate. You’re able to control an expensive piece of property with a small down payment.
Because you’re investing only a small amount of your own money, you’re able to use the balance of your remaining cash to invest in other financial vehicles and, thereby, expand the interests of your investments far beyond what you could if you had to pay the full amount for each investment.
It’s similar in the trading world. For example, you can trade futures and forex because they often give 20-to-1 or even 50-to-1 leverage. Controlling a large amount of money by investing only a small amount of money allows you to make more money faster.
As an example, if you place an order for one lot on a forex pair that’s worth $100,000, you may be able to open that order by investing only $2,000; however, you can make money based on the $100,000 value of the currency pair.
On the other hand, you can also lose the amount of money based on the $100,000 value of the currency pair! That’s exactly what the saying, “Leverage is a double-edged sword,” means.
Margin: The requirements for the privilege of using leverage
In keeping with the comparison to buying a house using a mortgage, to open a leveraged position in the market, you’re required to make a down payment. Brokerage firms operate a little differently than buying a house in that you’re not actually putting down a small percentage of the value of the real estate to one day own it.
When trading, you put up a percentage of the financial vehicle’s value to control the full value you’re buying. This is called margin, which functions as a “good faith deposit.” The margin requirement is the amount of money a trader is required to have in his account to control a certain order size. It’s based on a percentage of the value of the entire order.
With stocks, the margin requirement is typically 50 percent (or 25 percent for qualified day traders). With futures, the margin requirement is often around 5 percent. With spot forex, the margin requirement is at most 2 percent in the United States (and can be lower in other countries).
If you’re losing money and the value of your open positions (the money you still have invested in the market) goes below your margin requirement, you may receive a margin call. When this occurs, your broker will typically close the position you have open in the market unless you add more funds to your account.
Leveraged investments can be riskier than those that aren’t leveraged because the balance of the money you’re controlling, minus your “down payment” (margin), is borrowed money. If the market were to tumble catastrophically, beyond your down payment, you’d owe the full amount (plus potential interest on the borrowed money).
Be sure to talk to your broker and ask about your maximum risk exposure based on your account. Some brokers offer technology that attempts to limit your maximum loss to the funds in your brokerage account.
FAQs
Margin: The requirements for the privilege of using leverage
What is margin and leverage for dummies? ›
Leverage allows you to trade a larger financial position with a smaller sum. Margin, on the other hand, is the initial investment you need to make to open a leveraged trade. Combined, margin and leverage allow you to leverage the funds in your account to potentially generate larger profits than your initial investment.
Is 1/500 leverage good for a beginner? ›
Some may even offer leverage as high as 1:500. While this may seem enticing, it is not recommended for beginner traders. High leverage can lead to significant losses and should only be used by experienced traders who have a thorough understanding of the markets and proper risk management strategies.
How do you explain leverage in trading? ›
Leverage is the use of borrowed funds to increase one's trading position beyond what would be available from their cash balance alone. Brokerage accounts allow the use of leverage through margin trading, where the broker provides the borrowed funds.
What is a margin for dummies? ›
Margin is the money borrowed from a broker to purchase an investment and is the difference between the total value of an investment and the loan amount. Margin trading refers to the practice of using borrowed funds from a broker to trade a financial asset, which forms the collateral for the loan from the broker.
Which is better margin or leverage? ›
Level of Risk
The risk associated with margin trading is low. If the market moves against your expectation, your loss is limited to the interest that you pay towards the borrowed amount. Leverage trading can be very risky. If the market moves against your position, your losses may be amplified significantly.
What is leverage in simple words? ›
to use something that you already have in order to achieve something new or better: We can gain a market advantage by leveraging our network of partners. SMART Vocabulary: related words and phrases.
What is the best leverage for $100 for beginners? ›
This is because of poor risk management skills and sometimes the leverage in use. Many professional traders say that the best leverage for $100 is 1:100. This means that your broker will offer $100 for every $100, meaning you can trade up to $100,000.
What leverage should I use for a $10 account? ›
Here's a general guideline for determining optimal leverage based on account size: Account Size: $10 - $50 Recommended Leverage: 1:100 or lower. Account Size: $100 - $200 Recommended Leverage: 1:200 or lower. Account Size: $200+ Recommended Leverage: 1:300 - 1:500 (for experienced traders)
What is the best leverage for $5? ›
Generally, it's recommended to use lower leverage when you have a smaller account size to minimize the risk of significant losses. A leverage of 1:10 or 1:20 can be a good starting point for a $5 account.
While you are not required to repay the leverage itself, you must maintain a sufficient amount of capital in your trading account to cover potential losses. If your account balance falls below the required margin level due to trading losses, you may receive a margin call from your broker.
Can you trade without leverage? ›
Trading forex without leverage means you will only earn profits based on the actual movements of the currency pairs you trade. With leverage, you can amplify your profits by using borrowed funds. However, this also means you will earn lower profits when you trade without leverage.
Can you lose more than you invest with leverage? ›
Using leverage can result in much higher downside risk, sometimes resulting in losses greater than your initial capital investment. On top of that, brokers and contract traders often charge fees, premiums, and margin rates and require you to maintain a margin account with a specific balance.
How do I figure out my margin? ›
The margin is the gross profit divided by the total revenue, which creates a ratio. You can then multiply by 100 to make a percentage. In this formula: Net sales can be used interchangeably with revenue for the sake of this formula — it is simply how much money was generated from selling products, goods, or services.
What is the basic formula for margin? ›
To find this, divide your gross profit by revenue. Multiply the total by 100 and voila—you have your margin percentage. The margin formula measures how much of every dollar in revenue you keep after paying expenses. The greater the margin, the greater the percentage of revenue you keep when you make a sale.
What is a respectable profit margin? ›
An NYU report on U.S. margins revealed the average net profit margin is 7.71% across different industries. But that doesn't mean your ideal profit margin will align with this number. As a rule of thumb, 5% is a low margin, 10% is a healthy margin, and 20% is a high margin.
What is margin for beginners? ›
Generally speaking, buying on margin is not for beginners. It requires a certain amount of risk tolerance and any trade using margin needs to be closely monitored. Seeing a stock portfolio lose and gain value over time is often stressful enough for people without the added leverage.
What is a margin call simple explanation? ›
A margin call is a demand from your brokerage firm to increase the amount of equity in your account. You can do this by depositing cash or marginable securities to your account or by liquidating existing positions to generate cash.
How do you explain margin to someone? ›
- a. : the difference which exists between net sales and the cost of merchandise sold and from which expenses are usually met or profit derived.
- b. : the excess market value of collateral over the face of a loan.
- d. : a range about a specified figure within which a purchase is to be made.
Financial leverage is the use of borrowed money (debt) to finance the purchase of assets with the expectation that the income or capital gain from the new asset will exceed the cost of borrowing.
