Understanding Margin Trading and Leverage
The proliferation of the Financial Markets offering different asset classes over the years has given individuals and institutions a plethora of avenues to grow and accumulate their capital.
A testament to this is the different types of instruments available to the public market – Futures, Options, Warrants, Mutual Funds and Exchange-Traded Funds (ETFs), Hedge Funds, catering to different objectives and risk appetite.
This resulted in the emergence of multiple brokerage platforms, where trades and investment decisions can be executed from any internet-connected device. Many of these online trading services have revolutionised the transactions of financial instruments, creating a more robust and interconnected financial ecosystem.
Day Trading involves the buying and selling of securities within the trading day, occurring in any marketplace. Some of the more commonly traded instruments are Forex and Equities (commonly known as stocks).
In this article, we will be exploring Margin Trading – a tool that uses Leverage to enhance a trader’s buying power, potentially amplifying one’s returns and losses.
What is Leverage?
Leverage refers to the use of debt (borrowed funds) as a funding source when investing to expand the trader’s asset base and generate returns on risk capital. The concept of Leverage in trading/investing is a strategy of using borrowed money (in terms of financial instruments or cash capital). This allows investors to multiply their buying power in the market, as well as to multiply potential returns from an investment.
However, if an investor uses leverage to make an investment and the investment moves against the investor, their loss is much greater than what it would have been if they had not leveraged the transaction.
Leverage is facilitated by Margin – the minimum amount of cash that you need in order to be allowed to trade using Leverage. This allows investors to borrow capital from a broker when opening positions (i.e. Long/Short). Margin is not the only way to generate leverage, as different strategies can be employed that circumvent margin accounts.
What is Margin Trading?
Trading on margin allows traders to borrow funds from their brokers to purchase more units of security than the cash in their account would allow for on its own. This also applies to short-selling.
Buying on margin facilitates trading for those who lack a sufficient amount of cash on hand – this enhances the buying power of traders. The shortfall in cash is filled by their brokerage firm (at an interest rate stipulated by the brokerage firm). The use of margin increases the risk exposure of traders, which can result in higher potential returns or losses.
Margin Trading is subjective to every trader and investor and there are Margin Requirements to be met:
- Initial Margin
- The amount of cash (or market value of eligible securities) that must be deposited into the margin account.
- It is calculated as a percentage of the purchase price of a security that must be covered by cash or collateral.
- Minimum initial margin requirement set by the Federal Reserve Board’s Regulation is 50%, but brokerage firms can set higher than 50%
- Maintenance Margin
- The minimum amount of equity that the traders/investors must maintain in the margin account after the purchase of security has been made.
- Currently set at 25% of the total value of securities in a margin account.
- Margin Call
- A margin call occurs when the value of the trader/investor’s margin account (total market value of securities) falls below the maintenance margin.
- Traders/Investors are required to deposit additional capital or sell their securities to meet the margin call to bring the margin account back to the minimum maintenance margin.
It is crucial to note that if a trader or investor does not meet the margin call, the brokerage firm can close out any open positions (sale of your securities) in order to bring the margin account to the required maintenance margin.
The broker is allowed to do so without the investor’s approval and can choose which assets to liquidate. Commissions might be charged for the transactions as well.
Benefits of Margin Trading
- Increase in Purchasing Power: Margin trading allows traders who do not have sufficient cash to buy/sell securities beyond their capacity due to the use of leverage (borrowed funds).
- Yields Higher Returns: Despite the cost of financing (interest fees on borrowed funds), employing leverage would mean that the amount of cash/equity you use to transact would be lower, thus multiplying your returns on equity (ROE).
- Non-cash Collateral: An individual’s securities in the portfolio can be utilized as their collateral.
Risks of Margin Trading
- Larger Downside: Although leverage can help traders magnify profits, it can also magnify losses. Unfortunately, one can risk losing more than what they initially invested. In essence, borrowing from brokers is as binding as borrowing from a bank.
- Margin Calls and Maintenance Margin: Generally, an individual is supposed to consistently maintain a minimum balance within their margin account. Assuming one’s balance falls below the minimum threshold, a margin call will occur.
- Liquidation of Portfolio Holdings: Brokers maintain the right to initiate actions against traders who fail to fulfil their maintenance margin. This means that if one fails to meet a margin call, the broker can liquidate their assets to recover the borrowed funds, even before the position’s Stop Loss conditions are met.
The use of Leverage in Forex Trading
With a larger market position, leverages allow investors to amplify their profit potential based on the amount leveraged. This means that investors can significantly increase the size of their holdings, thus increasing their overall market gain.
However, on the downside, investors can incur considerable losses than their original capital, if the value of the market position goes below their original market entry price.
To further exacerbate things, many forex brokers offer high leverage ratios of over 400:1, which is extremely dangerous and can pose a risk of severe losses.
Since trading with leverages augments the risk of magnified losses, you can manage risk with mechanisms like:
- A stop-loss order to close a trade.
- Instituting a take profit order to automatically close your position when profit on your trade hits the amount you choose.
Main differences between leverage and margin
- Margin is the amount of money necessitated to open a position, while leverage is the exposure to account equity.
- Leverage is expressed as a ratio while Margin is expressed as a percentage
- A margin is essentially a loan provided by a broker to purchase securities, stocks, or commodities, while leverage is a temporary loan that leverages one’s stock position.
- With Leverage, investors pay a specified amount of interest annually. Furthermore, investors can keep them for as long as they desire, as long as the annual interest is paid. Individuals can choose to stop paying interest when they close their position.
What is the Relationship Between Leverage and Margin?
Since we have established that investors use margin to create leverage, this means that you cannot trade with leverage without having margin. It’s also worth noting that leverage increases the “trading power” available when using a margin account.
Leverage is typically expressed as a ratio between the amount of money an investor really has and the amount of money they can trade. The leverage ratio is generally expressed in a “1:X” format, for example, 1:100 or 1:500.
In practice, this ratio denotes that for every $1 the investor deposits into his/her account, he/she can enter into trades worth $100 or $500.
Generally, Leverage ratios and Margin requirements vary from broker to broker, though the amounts usually offered are 100:1, 200:1, and 50:1.
Furthermore, the Leverage ratio offered is also dependent on the trade size of the position.
For example, a minimum margin requirement of 0.5% is technically the same as 200:1 leverage, while a leverage ratio of 100:1 would be 1%.
While such leverage can often be found in retail brokerages, larger financial institutions do not offer such leverage due to risk.
Ultimately, these two verticals are closely interrelated, and it might be initially challenging for new investors to spot the differences between them, their manner of application, and the context in which they are applied.
Nonetheless, trading on margin can be profitable, but also fraught with risk given the fact one can potentially lose their entire investment.
The amount of leverage depends on the margin rate requirements, which vary between each trading instrument, depending on market volatility and liquidity.
However, this does not mean that Leverage must be avoided altogether but rather used safely.
As you trade or invest, remember to manage your risk and only open positions within your means (i.e. Do not keep too many open positions or over-leverage, simultaneously).
Another risk-mitigation measure can be choosing a reputable, high-quality broker who provides access to responsible leverage levels. Such brokers will protect you from placing riskier trades, and your available margin will always be displayed clearly and updated immediately.
Associate Director, FX Algorithmic Trading
Zhi Xin has spent the last 10 years across various roles in the banking and financial services sector. Prior to joining Salzworth, she was in the Vistra Alternative Investments team leading their SEA regional business development efforts, working closely with fund managers from private equity, venture capital and hedge funds to launch new fund structures and provide fund administration solutions.
Zhi Xin is part of the Salzworth FX team and is focused on sales and business development efforts for the Salzworth Global Currency Fund.