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The concept of margin trading has a rich historical backdrop, originating in the late 1800s to fund railroad ventures. It gained popularity in the 1920s due to loose margin restrictions that allowed investors to risk just a tiny amount of their own funds. However, inadequate margin regulation led to a financial disaster, as seen by the Stock Market Crash of 1929.
Now, leverage and margin are primary components to boost one’s trading experience, and today’s more regulated and systemised financial environment makes it more achievable. So, let’s talk about the differences and commonalities between margin and leverage and how you can use this opportunity to grow your capital.
Leverage means borrowing money to fund a project and increase the amount you can make from it in the future.
Margin is money moved to your broker's account to trade with leverage.
Both margin and leverage trading aim to increase an investor’s return.
Though margin and leverage trading look similar, they have some significant differences.
What is Leverage in Trading?
Leverage means borrowing money to fund a project and increase the amount you can make from it in the future. Leverage trade generally means that you borrow funds to trade. It implies the ratio between the money you invest and the amount of money you can trade with after taking on debt. In simple words, leverage is a ratio of borrowed funds and margin.
So, how does leverage trading work?
Leverage allows traders to trade large-volume positions using a small initial deposit. Traders borrow money from their brokers to increase their purchasing power when placing orders.
Once a trading position opened by a trader using leverage is closed, the borrowed money is returned to the broker, and the trader either makes a profit or suffers a loss, depending on the result of the trade.
Leverage enables a trader to increase their potential profit by the leverage ratio, which can be very profitable if the market moves upwards. However, you can also lose if the market moves against you.
Leverage is usually shown as a ratio, like 2 to 1, 10 to 1, or other, depending on the type of asset and the rules set by the broker. For example, a 10:1 leverage means the trader can borrow $9 from the broker for every $1 of their money. If you have $1,000 in your trading account and a stock traded at $20 per share. If no leverage is applied, you can buy 50 shares with the given amount. However, if you use a 10:1 leverage ratio, you can effectively control a position worth $10,000, which allows you to purchase 500 shares of the stock ($10,000 / $20) instead of 50 shares without leverage.
Leverage trading is a popular FX trading strategy, and some experts use margin accounts for leverage. Using a leverage calculator, you can calculate your leverage ratio and the amount of leverage you need to open a position.
To open and maintain a leveraged position, a trader must provide a portion of the trade value as a deposit. This deposit is known as the margin.
Pros and Cons of Leverage Trading
Using leverage is a very effective way for traders and investors to get significant returns. However, like any trading strategy, leverage trading comes with benefits and some drawbacks. Let's discuss them in more detail.
Potential for higher returns with a minimal deposit - When trading large positions, you can profit more than trading without borrowing money.
Better access to high-priced stocks - Using leverage, you get more money from your broker, meaning that the amount you invest will be much more considerable than what you started with, resulting in more significant profit.
Funds efficiency and access to many markets with limited capital - Using leverage allows you to access more extensive investments in different markets and have more money available for other opportunities.
Fast losses - Even if the market moves against you just a bit, it can make you lose more money or sometimes even all the money in your account.
Overleveraging - This occurs when you have too much debt or borrow more money than you can afford to repay.
Interest charges - These are the additional amounts of money you must pay back when you borrow money from your broker. The amount of interest you have to pay depends on how long you keep the loan and can lower your total earnings.
What is Margin Trading?
Margin is the amount of money you need to open a trading position, and leverage is the factor by which the margin on your deposit is multiplied. The initial margin is the amount of money or assets an investor has to put aside when buying a security using a margin account. It's a percentage of the total purchase price. This type of trading is very common in the Forex market.
Margin is money transferred to your broker's account to trade with leverage. This deposit guarantees that you can trade using borrowed funds, and the margin can be used to cover any losses you have when trading. If you refuse to deposit additional funds, your broker can decrease your investment amount to mitigate the potential risk. If an investor's money in a margin account drops below the amount the broker asks for, a margin call occurs.
Regardless of market conditions, the margin is the assessed value of your assets in the broker's trading account that is used as collateral when trading with leverage.
There are specific rules for margin trading. Thus, first, you must open a margin trading account with your broker and ensure that it holds pre-agreed amounts of money or securities.
Margin interest rates are lower than other forms of borrowing, such as credit cards or unsecured loans. However, margin trading is always riskier than regular trading without leverage. If trades are not executed in your favour, you may lose the borrowed funds that you will still need to return with interest, plus you may have to incur additional expenses.
Using a margin calculator, you can calculate the exact margin you need to open a trading position.
Pros and Cons of Margin Trading
Margin trading implies that you borrow money to buy more things that can make you money. It aims to increase profits, but there can also be disadvantages despite the benefits.
Potential for significant return - The best thing about margin trading is that it allows you to make more significant profits thanks to the fact that you can borrow more money.
More opportunities for trading - There are more chances to trade because you can buy more assets when trading on margin.
Application of advanced trading strategies - You can use more complex strategies that involve making money by trading options.
Increased risks - You might end up losing the money you invested initially and the additional money you borrowed from the broker.
Interest on loans - Buying on margin can lead to paying interest on borrowed funds, which can be higher than the prime rate.
Leverage vs. Margin Trading
Both leverage trading and margin trading involve borrowing money from a broker to increase the size of a trading position. However, they also have some differences.
The core difference is conceptual: margin trading implies investors borrow money to increase their trading power. At the same time, leverage means applying for a loan to buy an asset or fund a financial activity.
Another essential discrepancy between margin and leverage is that, unlike leverage, margin trading uses collateral in your margin account to borrow money from a broker, which is paid back with interest, acting as leverage to enable larger trades.
Further, the relationship between margin and leverage is inverse, with higher margins resulting in lower leverage.
Moreover, conservative leverage strategies are better at reducing risks over long periods, while short-term margin investments can result in good returns in markets with high liquidity.
Leveraged trading and margin trading can be good tools for those willing to increase their initial investment and investments' risk-return ratio. Both types of trading involve the possibility of opening large trading positions with little capital. However, both trading options come with serious risks that should be considered.