Leverage and margin are often confused as the same thing in financial trading terms. Within this guide, we’ll explore the nuances of trading with leverage and trading with margin. We’ll also cover the concept of leverage ratio and the ideal ratio for novice traders, as well as risk management when using leverage to trade various financial instruments.
This article at a glance:
- Leverage allows you to trade larger volumes using a smaller deposit through a ‘loan’ from your broker.
- This multiplies the profits you may make relative to your deposit. It also compounds the losses you may incur.
- Pay attention to risk management strategies when trading with leverage.
What is leverage?
CFDs are a popular leveraged product with those who look to take advantage of minor movements in the prices of different assets. In the context of CFD trading, leverage is a facility offered by your CFD broker that gives you heightened exposure to the markets you trade.
In basic terms, consider leverage as a loan offered by your CFD broker that allows you to increase your exposure by a set ratio. For instance, if you take leverage offered at 50:1, this means for every unit you deposit, you will get 50 times the exposure in the market. It also magnifies your profits and losses by 50 times.
Imagine you wish to trade oil at a notional value of 100000 USD. Without leverage, you would have to shell out the entire value as a deposit to be able to trade for this amount. With a leverage of 50:1, however, you would only need to deposit 2000 USD (100000/50). Your broker would lend you the rest.
Leverage is widely used in forex trading due to the amount of capital required to profit from small price changes. It’s also used by derivatives traders, allowing them to maximize positions on over-the-counter (OTC) and exchange-traded contracts.
Pros and cons of leverage trading
- Potential profits are based on the full value of your position, not the initial amount deposited towards the trade.
- Leverage is available 24/7 on certain markets, including forex and prime indices.
- Leverage frees up capital to put to good use in other investments – a concept known as ‘gearing’.
- Potential losses are also based on the full value of your position, not just the amount you deposited. You risk losing more money than you actually have.
- You are at risk of margin calls (explained below), with your broker requesting you to deposit additional funds if your position moves against you.
What is margin?
Margin is the amount your broker requests for you to deposit to open a new position with leverage. As leverage is measured as a ratio, margin is usually measured in percentage terms relative to the full exposure of the open position.
Typically, the larger the leverage you wish to use, the smaller the margin percentage will be.
What is a margin call?
When trading with leverage, your broker may issue you a margin call. This is a warning that your margin has fallen to a preset level (set by the broker). At this point, you will need to either close the trade to cap your losses, or deposit additional funds to maintain your open position.
What is a margin stop?
The last thing you want to encounter when trading with leverage is a margin stop. This occurs when your margin falls to a predetermined percentage level, forcing your broker to liquidate all open positions. .
Leverage ratios for beginner traders
Here’s how leverage influences your margin requirements on a trade of 10000 USD.
Typically, the most volatile financial instruments will offer lower leverage to safeguard traders from sudden price volatility. At the other end of the spectrum, highly liquid markets with deep order books like the forex market can carry higher leverage ratios.
Managing risk when trading with leverage
Consider these risk management approaches you can take to trade with leverage:
- When making trading decisions, always remember that leverage multiplies your potential profits, but also multiplies your risk of loss.
- Set an acceptable total risk per trade – potentially between 0.5-2% as per most professional day traders.
- Choose a risk-reward ratio that ensures your strike rate is profitable. For example, trading with a 1:3 risk-reward ratio only requires you to win 30% or more of your trades to be profitable.
- Leverage ratios can range from 50:1 to as high as 1000:1. Beginner traders would need to consider starting at a safer leverage ratio, and keep all related risks in mind.
This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. INFINOX is not authorized to provide investment advice. No opinion given in the material constitutes a recommendation by INFINOX or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.