Leverage and margin explained
Let’s start with leverage. Leverage is a catch-all term for when you use borrowed money to invest. You hope the profits will be greater than the interest payable on your borrowing. A business might borrow several times its profits to enable it to expand.
Homebuyers take out mortgages of several times their earnings. The downside is that if the investment falls, your original cash could be simply eaten up and you would still have to pay the ongoing borrowing cost. In the house-buying example, this would leave you with negative equity where you owe more to the bank than your house is worth.
In financial trading, leverage allows you to make bigger trades from the financial markets than you might otherwise have the cash for. You are being lent the balance to trade from a broker. This means your capital is freed up for other investments.
Although you only put up part of the money, your profit or loss will be based on the total value of your position, which is larger because of the borrowed money.
There is the potential to see a profit or loss of more than your original investment. But, it always pays to know the risks in full.
Trading ‘on margin’. What does it mean?
Margin is a form of borrowing from a broker that enables you to trade more assets using borrowed money, so you can deploy your own funds elsewhere.
There are specific rules and you must first establish a margin account with your broker and ensure pre-agreed amounts of money or other securities are kept in it.
Margin interest rates are lower than other forms of borrowing, such as credit cards or unsecured loans debt.
But borrowing ‘on margin’ is always riskier, sometimes a lot riskier, than non-leveraged trading. If the trades go against you, you can lose the borrowed money too – and still have to pay it back with interest, plus other possible miscellaneous charges.
Your margin broker will set a leverage ratio or maximum leverage for you. For a retail investor on a trading platform, this might be 1:50. A ratio of 1:50 means that for every £1 you want to trade, the maximum the broker will lend you is £50. Your margin payment is just 2%.
In all likelihood, the maximum for an individual trade will be lower due to the asset’s perceived risk. Trading in financial instruments that do not involve owning the underlying asset, such as CFDs, have a much lower margin than trading directly in shares, for example.
You can help yourself by not borrowing the maximum a broker will offer you, giving yourself more leeway.
A few tips on margin
Quite modest sums borrowed on ‘margin’ allow you to (potentially) make, and lose, money from forex, stocks and other financial instruments. In other words, for every strong gain there is the potential for a severe loss.
It’s advisable to trade only what you can afford to lose and that you understand the risks. You may possibly consider seeking independent advice before you do.
You need to keep cash or other securities in your account as a guarantee that you can repay any losses.
Your broker has the authority to sell these other securities without your consent to ensure a loan is repaid. That means you may lose the chance to wait for a stock to bounce back in value.
Think very carefully about your trading goals, long and short term. Many new investors focus on potential gains rather than minimising risk for themselves and reducing the chance of serious losses. Preserving your capital and managing stress levels is vital.
Remember, you can ‘test drive’ your skills first using our practice demo account. It’s strongly advised. See how small movements in price can affect your trading strategy in a big way.