When it comes to investing and trading, leverage and margin are two terms you will hear thrown around often. People familiar with markets will be aware of what they represent; however, if you are new, they might seem confusing at first since, at most times, they are used interchangeably.
On a deeper level, there is a difference, which will be covered in this piece, plus how using both can benefit you as a trader.
Does margin relate to leverage? The answer is yes. Leverage is the ratio between the amount of money you might have in your account and the amount you can trade with. In simple terms, leverage allows you to gain greater exposure to financial market positions with a small amount of capital.
On the other hand, margin trading resembles leverage in principle. Interestingly margin is used to create leverage; the only difference is that margin is expressed as a percentage deposit required while leverage is expressed as a ratio.
For example, if a 5% margin is required, this equates to a leverage of 20x, or a 2% margin is equal to a leverage of 50x, and so on. Using the example above, if you have $1000, you can take a $20,000 position.
That said, you will find that margin trading is mostly used in futures markets. In contrast, leverage is used when spread betting or trading contracts for difference (CFDs).
Benefits Of Using Leverage
This section will explore the benefits of using leverage in trading.
Frees up capital
This is one of the main appealing reasons most people are attracted to leverage trading. You just need a fraction of the amount required to open a position. This frees up your capital which can be utilized to take other positions.
Ability to take larger positions
If you were trading on the spot market where you have no access to leverage, then you have no option but to use only the amount in your account to take positions. However, with leverage, you can take a position that is 10x or even 100x the size of your capital. This helps get the most out of your capital, and you can allocate it to many other assets instead of being restricted to one or a few.
Your profits are multiplied
The idea of using a fraction of the capital to access gains of the actual position is why every trader loves leverage. Done correctly, leverage can help your account grow tremendously in a short span. Most seasoned traders have mastered using leverage to profit and expand their accounts, allowing them to take even larger positions.
Shortcomings of using leverage
Just as in life, everything good has a bad side. Leverage and margin trading are great for the reasons mentioned above; however, they carry some significant risks.
Your losses are multiplied
When the trade goes your way, your profits are multiplied, and the opposite is true. Therefore, your account can get wiped out pretty fast. Sound risk management is required to guard your capital. Also, you need to practice disciplined trading to avoid losing everything in no time.
If the market goes against you, you will be required to add more funds to maintain your position. Therefore, the platform you are using will demand you deposit additional funds to bring your account to the minimum value. This is known as a margin call and occurs when your balance and unrealized profits and losses are equal to their margin requirement.
That said, margin and leverage trading is a great way to build your account and earn more than spot trading. However, it’s not a walk in the park. You need to know what you are doing; otherwise, you will lose your capital. This means investing time and resources to learn how to conduct technical and fundamental analysis. Also, learn sound risk management as it makes all the difference in trading.