Professionals have their own jargon that they need to learn to better understand their craft. That’s the same with traders. Traders need to understand the terminologies brokers and markets use. In this article, we explain the meaning, difference, and the relationship of two most common trading terms: leverage and margin.
What is Leverage?
Simply put, leverage is your capability to pay only a small amount of money to control large trade sizes. With leverage, you’ll be enjoying smaller initial outlay.
For instance, your broker may set aside $1,000 from your account for you to control, say, $10,000. Your leverage will then be 100:1, meaning you control $100 for every $1 in your account. You control $10,000 worth of trade, but you’re only using $100 to do that. Isn’t that tight?
This also means that increases or decreases in the trade price will also get magnified. In other words, even if leverage can work very much in your favor, it can also break your trade.
That’s why you must think carefully about how much leverage you want to use on your trading account. Remember, bigger rewards usually come with bigger risks.
What is Margin?
In the world of trading, the term ‘margin’ sometimes has multiple definitions. Some traders think margin is the fee that they owe the broker.
But it’s actually a ‘good faith’ deposit, or the collateral that the broker gets to hold an open position. In other words, it’s not a transaction fee. Rather, it’s the money that ensures you have sufficient balance in your account relative to your position size.
Further, the broker uses this good faith deposit to add it to the everyone else’s margin. The total amount, then, serves for when the broker places trades within the interbank market.
Now, again, don’t get confused. This here is forex margin, while there’s yet another type of margin, this time for equities.
Equities margin refers to the money you borrow from the broker as a partial downpayment to buy or own a stock, bond, or a fund. So, when you’re trading stocks and you want to ‘trade on margin,’ you’re basically taking a loan from the brokerage firm.
Now, to help clarify some confusions surrounding the term margin, here are some key points to remember:
- Margin requirement – the amount of deposit you pay for you to open a position.
- Account balance – the total amount of money that you have in your account.
- Used margin – the locked-up money to keep your current positions open.
- Usable margin – the amount of money you can still use to open new positions
- Margin call – the notice you get when the amount of money in your account cannot cover the possible losses.
The Relationship of Leverage and Margin
From those definitions, the relationship of leverage and margin gets a bit clearer for newbies.
The margin serves to create leverage, which is the higher control you get on the amount of trades. That is, of course, when you’re using a margin account.
Leverage lets you control bigger for smaller prices, and the margin, or good faith deposit, you give your broker, lets you control leverage.