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If you have ever traded on financial markets before, you might have heard the terms ‘margin’ and ‘leverage’.
Both of these terms refer to the process of borrowing assets from a broker to amplify the purchasing power of your trading account, which can lead to outsized gains when trades go well, but also higher losses when they don’t.
While most traders tend to stick with their own capital, leverage and margin are nonetheless popular methods of increasing purchasing power to trade on capital markets.
If you are a beginner trader and would like to know more about margin and leverage, as well as the difference between the two terms, this investfox guide can help you out.
In financial trading, margin refers to the amount of money a trader needs to put aside in their trading account to open and maintain a trading position.
It's a portion of the total value of the position that the trader is required to have in their account as collateral.
In general, a margin acts as a security deposit that ensures that the trader has sufficient capital to cover the losses that may arise from a given trade.
Margin trading is typically done using margin accounts and is especially popular among Forex traders.
There are two distinct types of margins:
To sum up, margin refers to the amount of money you need to have in your account in order to open and maintain a trade position.
The term ‘leverage’ refers to the ability to control a larger position in the market with a smaller amount of capital. It's expressed as a ratio and represents the multiplier by which your trading position is magnified relative to your margin. For example, if you have a leverage of 20:1, it means that for every $1 of margin you have, you can control a trading position worth $20.
Leverage can be a double-edged sword for traders, as it can amplify both potential gains and losses. While leverage does allow you to make larger trades with a smaller initial investment, it also increases the risk because losses are also magnified. High leverage can lead to significant gains if the trade goes well, but it can also quickly deplete the trading account if the trade moves against the trader.
In short, leverage is the ratio that shows how much larger your trading position is compared to your margin. Depending on what you’re trading, leverage may either be essential, or counterintuitive to your trades.
Now that we have a clear definition of what margin and leverage mean, it is important to look at a few uses of them in different financial markets.
Some assets are much more useful for margin and leverage than others. For this example, let’s compare Forex and stock trading to see how they can be used to boost returns.
Margin trading and leverage are very popular among Forex traders, as the Forex market is characterized by extremely tight bid/ask spreads and slim profit margins.
Traders use leverage to amplify their positions and increase gains from each trade.
Furthermore, Forex brokers typically allow for some of the largest leverage ratios on the market - ranging from 20:1 to as high as 1000:1 in some cases.
Day traders almost always use leverage to open positions worth millions of dollars, while only putting thousands at risk.
When it comes to stock or crypto trading, leverage is typically reserved for trades that go against the market. For example, a trader that anticipates a drop in the price of a particular asset can sell those assets short by borrowing the same asset from the broker and after the price hits a certain lower level, sell the asset, repay the broker, and pocket the difference as their profit.
Short-selling is an even riskier method of trading but is nonetheless popular among bearish traders who anticipate a market downturn.
While margin and leverage are often used interchangeably, margin refers to the amount of money needed to open and maintain trade positions, while leverage refers to the ratio that shows how much larger a trading position is compared to the margin.
Margin and leverage are useful when you want to substantially increase the purchasing power of your account. This is done by multiplying your initial margin by the leverage ratio.
The leverage ratio you can get depends on your broker, as well as the instruments you are trading. For example, Forex traders can get up to 1000:1 leverage, while stock traders usually get 2:1 or 3:1.