For beginner traders, it can get confusing to tell the difference between specific trading terminologies like margin and leverage. If you’re in this position, you’re not the only one. Margin and leverage are two terms that often get confused or misunderstood.
Some people use them interchangeably when referring to the type of trading they are associated with, which is further confusing. In this article, we’ll explain in clear terms exactly what margin and leverage are and the difference between both of them.
Margin vs. Leverage: What’s the difference?
Margin and leverage are two terminologies commonly used when discussing or implementing margin trading, a common trading strategy in trading forex, stocks, or cryptocurrencies. So let’s look at both terms individually.
What is leverage?
In trading, leverage is the amount you borrow from your broker to make up the balance for the trade. In other words, leverage increases your purchasing power to fulfill a trade you ordinarily can’t afford, thereby increasing an investment’s potential return.
You could also refer to it as the ratio or multiple of your deposit relative to the amount borrowed. Leverage can appear anywhere from 5x to 10x to 20x or as high as 30x. In terms of ratio, your leverage can be 1:5, 1:10, 1:20, or 1:30.
What is Margin?
Simply put, the margin is the initial amount or deposit a trader puts up to initiate a trading position in the market. The margin or deposit also covers possible losses from your trade.
There’s a high possibility that if your trade ends negatively, you could lose all your margin or initial deposit. But if you make a profit, your margin remains intact.
Do these explanations seem bogus or unrelatable? Let’s look at both terms through the lens of the trading strategy they belong to, Margin Trading.
What is Margin Trading, and where do margin and leverage fit in?
Margin trading is a method that allows you to access a higher amount of trade using a small capital, a percentage of the total trade. It is also called leverage trading, margin finance, or margin trading.
It’s when you deposit a certain amount of money to take a market position while you borrow the rest from your broker. If the trade goes in your favor, you receive profits based on the total trade, not your initial deposit.
If the trade goes south, you could lose your initial investment and be required to cover the losses for your broker. However, you won’t lose everything because there are trading strategies for mitigating losses, like stop-loss.
Let’s break this down into a relatable example.
Example of margin trading
Suppose you want to take a market position with a notional value of $1000. If you had the total amount, you could go straight in and deposit all of it, putting all your capital at risk. However, you don’t need to have or use all your capital with margin trading.
If your broker allows a 1:10 or 10x leverage, you only have to deposit one-tenth or ten percent of the total trade. That means your margin is $100, and leverage is 1:10 or 10x. Your broker then provides the balance of $900.
With this example of margin trading in mind, you’ll understand the concepts better when we say that margin is your money and leverage is your broker’s money. You’re leveraging your broker’s money to cinch huge profits or, sometimes, losses.
Margin and leverage but in other examples
For a deeper understanding of these concepts, let’s look at them through real estate. For example, if you wanted to buy a house to resell for profit and didn’t have all the money, leverage allows you to put up a small deposit while the bank or a financier provides the rest.
Whether you make a profit or loss, you’re mandated to return the financier’s money in full. Sometimes, with interest.
Let’s say you have $20k and need $80k extra to buy a $100k house. The financier brings the additional $80k required. If you sell the house at $120k, you make a profit of $20k, return the borrowed $80k, and maintain your initial deposit of $20k.
However, if the real estate market were to tank and you can’t sell at a profit but instead sell at $90k, you’ve made a personal loss of $10k, and you’ll still have to return the borrowed $80k and maybe more if there’s interest attached. That’s how margin trading works.
Pros of margin trading
An obvious benefit of margin trading is the possibility of earning huge profits from a single trade using a small amount. In addition, with margin and leverage trading, you don’t need to delay entering a market position till you have more.
You only need to set your initial deposit and have your broker cover the rest. Another advantage of margin trading is that you would have more capital to enter other trades. Without this trading method, if you only had $100, you’d have to use all of it or find more.
But with the existence of margin trading, traders can spread their $100 across multiple investment streams. So while one portion goes to a leveraged trade, the others can go towards gold investments, silver, oil stocks, or cryptocurrencies.
Cons of margin and leverage trading
Margin trading, despite its benefits, also comes with its downsides. While it presents an opportunity to earn huge profits on a small deposit, it also opens you up to an equal amount of loss. The more leverage you use, the more losses you incur or the more profits you accrue.
If the trade goes sideways, you may lose all your initial investment or margin. That’s where trading strategies like stop-loss orders come in. Placing a stop-loss order can help you prevent the total loss of your investment.
Conclusion
Now that you know the difference between margin and leverage, you can study how best to reduce losses and maximize your margin trades for profits. Remember, the greater the leverage, the more experience and knowledge required to trade.
Knowing these terminologies is only one step forward in your trading journey. Newbies must maintain caution where margin and leverage trades are concerned.
