Margin and Leverage

What are margin and leverage?

Leverage is the use of borrowed capital to potentially increase the gains made on a trade, purchase, or investment. Note the use of the word potentially however, as the use of leverage does in no way guarantee gains. Any leveraged trade can still go wrong, giving the trader a far larger loss than they would wish. Because of this dynamic the use of leverage is always considered risky. Any time leverage is used it is equally important to employ some form of risk management to protect against a potentially disastrous loss.

Margin is related but slightly different. Margin is the act of borrowing money from your broker to increase your buying power. Margin allows a trader to put up just a small percentage of the value of an asset with their own money. This small percentage is called “initial margin” and it can be as small as 0.2% of the value of the trade in some cases, although it is far more common to see initial margin requirements of 1% to 5%.

What is a margin call?

Having access to margin is both useful and convenient, but it also comes with risks. As with any type of loan or financing there are risks that come from interest payments, reduced future income flexibility, and other financing risks. The largest risk however is the risk of a margin call.

When trading using margin, a broker requires you to keep a specific percentage of the borrowed funds in your account. If the value of the assets in your account drops below this specific percentage, the broker will require you to deposit additional funds to bring the account back up to this specified amount. This is a margin call. If you can't or won't increase the equity value of the account, the broker can close out any of your open positions to guarantee the return of their margin loan. And they can close those positions regardless of any current losses.

How leverage can magnify gains?

Leverage is used with the expectation that it will increase the gains made when trading. It does this by allowing the trader to open large positions with small amounts of capital. For example, if you open a position in gold with 1:100 leverage, you are only required to supply 1% of the value of the trade. This means that every $1 increase in the price of gold will increase your gains by $100. In this way you could potentially make a $100 investment and see a $10,000 return.

How leverage can magnify losses?

In the same way that leverage magnifies gains it also magnifies losses. So, in the same situation as above, where leverage of 1:100 is being used to trade gold, a $1 drop in the price of gold equates to a $100 loss for the trader. If they are only trading $100 that's a complete loss. So, the potential for losses to become extreme is quite dangerous when using larger amounts of leverage.

Benefits and Risks

Using margin increases risk, but also comes with a number of benefits when used properly. For example, margin will allow your capital to go much further, allowing you increased diversification benefits. And of course, leverage increases to potential returns you might experience on a trade. Margin also provides an easy avenue for financing since margin usage is typically pre-approved at the account level, which means no additional paperwork or applications and approvals are required. And the interest rates provided by brokers on margin are usually quite good.

While there are obvious benefits to margins, it wouldn't do to forget the potential pitfalls as well. While the expectation is that leverage will increase the return on a trade, it is just as possible that it could amplify losses. Trades could quickly go wrong when magnified by 100x, 200x, or even 500x. Traders also need to consider the overnight interest charges on any margin they are using, which could turn a winning trade into a losing trade. Margin interest is calculated daily, so each day the trade is open adds to the financing charges. The individual daily interest charge may seem small, but it can add up quickly. 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.