For
those considering investing, it’s important to first understand a few
key terms. These allow you to appreciate how the markets and trading
work, so you can form a strategy and make decisions that are beneficial
to your long-term goals.
Forming part of this core
terminology are two words: margin and leverage. “Margin” is a way for
investors to increase their buying power, which can be beneficial for
those whose budgets are modest. While it can increase profit, there’s
also a greater degree of risk inherent in it.
Perhaps
you’re also wondering “what does leverage mean in trading”? The two
terms are often used interchangeably. They both refer to ways to open a
trading position with a broker using only a small amount of capital to
take up a large position.
The use of these terms can be
confusing for amateur investors and those who’ve yet to enter the
markets. However, with this guide, you should soon develop a much better
understanding of them.
What is Leverage?
So,
what does leverage mean? In ordinary parlance, “to leverage” is to use
something to maximum advantage. Its meaning in the financial world is
not so dissimilar: you’re taking the funds you have and using leverage
to optimise your earning potential.
If you were looking
for a simplified leverage meaning or leverage definition, you might
summarise it thus: as a way to take a small amount of money and increase
its value on the investment markets.
Examples are often
the easiest way to explain this kind of concept. Imagine you have £1,000
to trade but want to increase your potential return. You find a broker
offering leverage at 25:1. With their backing, you could manage a
position of up to £25,000 by placing a deposit of £1,000.
What is Margin?
Above,
we said “leverage” and “margin” are two terms that are often used
interchangeably. This is true, but we should qualify it by explaining
that the two do have slightly different meanings.
If
you’re searching for a margin meaning, this is the amount of money
you’ll need to open your position, while leverage is the multiple of
exposure. If you’d like to know how to calculate margin, work out the
size of your intended position and then divide this by the higher
number.
Lots of brokers will have a margin calculator on
their page, but this is usually easy enough to work out in your head. In
the example we used above, our hypothetical broker wanted to trade
£25,000 with leverage of 25:1. The margin formula they’d need to use
would therefore be:
£25,000 / 25 = £1,000
Equally,
if the leverage was 5:1, they’d have to put down £5,000 to manage the
same size position. The formula in this instance would be:
£25,000 / 5 = £5,000
Essentially, this means you work out the margin in the following way:
Size of position / the higher figure in the ratio = the margin.
When
buying on margin, the size of your deposit will depend on the leverage
offered and the trading terms supplied by the broker. This payment is
known as the “initial margin”. Margin requirements can differ widely
depending on factors like the asset type, market, and risk involved.
How Does Margin Relate to Leverage?
We’ve
largely covered this question above, but let us go into a little more
detail here. Margin is, essentially, a special type of leverage that
involves using existing cash or securities positions as collateral. This
increases the trader’s buying power.
This ability is not
limitless. If traders have taken on too much risk, brokers may put them
on a margin call or implement a stop-out.
Let’s look at these two concepts individually:
Margin Call
A
margin call occurs when an investor’s balance and unrealised profit and
loss are equal to their margin requirement. The broker will demand they
deposit additional funds to bring their account up to the minimum
value.
Stop-out
A stop-out, on the other hand,
is the point where a trader’s equity is equal to half their required
margin. If you have trading positions open but lack the equity to cover
these, the trading platform will automatically close them. This is
implemented as part of the FCA’s product intervention measures.
How Does Leveraging Work?
So,
how does leverage work? This is a strategy that involves borrowing
funds to increase the return on investments. If the return is higher
than the interest owed, you can make a healthy profit, which is why
investors utilise it.
Using the GlobalCfdFinance platform,
you must decide whether you wish to use leverage or not. There’s no onus
on you to do so. Different instruments will have various maximum
leverage amounts. By law, these must not exceed a certain number.
You
can use a leverage multiplier to enhance your buying power. This will
often be in the form of a ratio, such as 10:1, 20:1, and so on. This is
the number of times your capital will be amplified.
If
you’re wondering “what is leverage ratio” and how you calculate the
leverage ratio formula, this is easy. The smaller figure relates to the
money you put down; the larger, to how much the broker will amplify this
by. So, if the ratio is 10:1 and you deposit £1,000 in your account,
the broker will increase this amount to £10,000.
Leveraged Buyout and Stop Loss
This
works in a not dissimilar way to a leveraged buyout.What is a leveraged
buyout? Where one company acquires another using a significant amount
of borrowed money. You’re essentially doing the same to secure a larger
position.