The Definition of Leverage and Margin
Forming part of this core terminology are two words: margin and leverage. “Margin” is a way for investors to increase their buying power, which can be beneficial for those whose budgets are modest. While it can increase profit, there’s also a greater degree of risk inherent in it.
Perhaps you’re also wondering “what does leverage mean in trading”? The two terms are often used interchangeably. They both refer to ways to open a trading position with a broker using only a small amount of capital to take up a large position.
The use of these terms can be confusing for amateur investors and those who’ve yet to enter the markets. However, with this guide, you should soon develop a much better understanding of them.
What is Leverage?
So, what does leverage mean? In ordinary parlance, “to leverage” is to use something to maximum advantage. Its meaning in the financial world is not so dissimilar: you’re taking the funds you have and using leverage to optimise your earning potential.
If you were looking for a simplified leverage meaning or leverage definition, you might summarise it thus: as a way to take a small amount of money and increase its value on the investment markets.
Examples are often the easiest way to explain this kind of concept. Imagine you have £1,000 to trade but want to increase your potential return. You find a broker offering leverage at 25:1. With their backing, you could manage a position of up to £25,000 by placing a deposit of £1,000.
What is Margin?
Above, we said “leverage” and “margin” are two terms that are often used interchangeably. This is true, but we should qualify it by explaining that the two do have slightly different meanings.
If you’re searching for a margin meaning, this is the amount of money you’ll need to open your position, while leverage is the multiple of exposure. If you’d like to know how to calculate margin, work out the size of your intended position and then divide this by the higher number.
Lots of brokers will have a margin calculator on their page, but this is usually easy enough to work out in your head. In the example we used above, our hypothetical broker wanted to trade £25,000 with leverage of 25:1. The margin formula they’d need to use would therefore be:
£25,000 / 25 = £1,000
Equally, if the leverage was 5:1, they’d have to put down £5,000 to manage the same size position. The formula in this instance would be:
£25,000 / 5 = £5,000
Essentially, this means you work out the margin in the following way:
Size of position / the higher figure in the ratio = the margin.
When buying on margin, the size of your deposit will depend on the leverage offered and the trading terms supplied by the broker. This payment is known as the “initial margin”. Margin requirements can differ widely depending on factors like the asset type, market, and risk involved.
How Does Margin Relate to Leverage?
We’ve largely covered this question above, but let us go into a little more detail here. Margin is, essentially, a special type of leverage that involves using existing cash or securities positions as collateral. This increases the trader’s buying power.
This ability is not limitless. If traders have taken on too much risk, brokers may put them on a margin call or implement a stop-out.
Let’s look at these two concepts individually:
A margin call occurs when an investor’s balance and unrealised profit and loss are equal to their margin requirement. The broker will demand they deposit additional funds to bring their account up to the minimum value.
A stop-out, on the other hand, is the point where a trader’s equity is equal to half their required margin. If you have trading positions open but lack the equity to cover these, the trading platform will automatically close them. This is implemented as part of the FCA’s product intervention measures.
How Does Leveraging Work?
So, how does leverage work? This is a strategy that involves borrowing funds to increase the return on investments. If the return is higher than the interest owed, you can make a healthy profit, which is why investors utilise it.
Using the eToro platform, you must decide whether you wish to use leverage or not. There’s no onus on you to do so. Different instruments will have various maximum leverage amounts. By law, these must not exceed a certain number.
You can use a leverage multiplier to enhance your buying power. This will often be in the form of a ratio, such as 10:1, 20:1, and so on. This is the number of times your capital will be amplified.
If you’re wondering “what is leverage ratio” and how you calculate the leverage ratio formula, this is easy. The smaller figure relates to the money you put down; the larger, to how much the broker will amplify this by. So, if the ratio is 10:1 and you deposit £1,000 in your account, the broker will increase this amount to £10,000.
Leveraged Buyout and Stop Loss
This works in a not dissimilar way to a leveraged buyout.What is a leveraged buyout? Where one company acquires another using a significant amount of borrowed money. You’re essentially doing the same to secure a larger position.
To minimise the potential risks when using financial leverage, you can utilise something known as a stop loss. This allows you to automatically close your position if you lose a certain amount. We also offer a maintenance margin feature that acts as an additional safety net. You can find more on this here.
To use leverage on our platform, you’ll need to do the following:
- Select the asset you’re interested in and click “trade”.
- Choose whether you want to sell or buy.
- Set the amount of capital you want to invest and your leverage multiplier. If you don’t wish to use leverage, you can choose “1x”.
- Set stop loss and take profit parameters.
- Click “set order”.
Examples of Leverage
We included a few examples above, but let’s consider a couple more in case you’re still asking “how do you calculate financial leverage ratio?”.
Let’s say you want to trade a EUR/USD currency pair at a ratio of 30:1. If you had £1,000 to trade, this would allow you to manage a position of £30,000.
Equally, if you wanted to trade a commodity like gold with leverage of 10:1 and you had £500 to spend, this would allow you to manage a position of £5,000. That’s because for every pound you deposited, the broker would contribute a further £10.
If in these situations you chose not to use leverage, you’d be able to open positions of £1,000 and £500 respectively.
What Can I Do to Minimise Risk When Trading ?
When assessing your leverage risk, try to put a risk management process or risk management framework in place. This should incorporate tools such as:
- Stop losses. Use these to automatically close trades when losses reach a certain amount.
- Take profit orders. Use take profit orders to automatically close positions when they reach a specified value.
- Negative balance protection. In some cases, brokers such as eToro will provide negative balance protection to guard against market conditions that cause equity to fall to zero. This means they absorb the loss on your behalf.
Used in combination, these tools should allow you to manage your level of risk.
What Are the Fees for Trading with Leverage?
This will depend on several factors (account type/Memebership), but you’ll always be made aware of fees before you place an withdraw.(Comission and fees).
- Management Fee
- Performance Fee
You can find more detailed information on this on account level pag
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