Securities markets present traders with great trading opportunities, which may at times require participants to have a relatively large capital that they may not be in a position to get. Under such circumstances, the traders may opt to borrow trading capital from their broker.
On their part, the lending entity (broker) usually asks for security to cover their losses in case the market goes against the trader’s position. The trader, therefore, has to present collateral to the broker.
In such instances, the trader’s collateral and the money they invest in the trade constitute a margin. The trader can obtain leverage, which enables them to trade beyond their actual financial ability. The concepts of leverage and margin are closely related but significantly different, as discussed below.
Margin trading is a form of trading whereby an individual uses collateral to obtain a loan, which they use to open their trading position. In technical terms, the margin is the difference between an investor’s actual capital held in their account and the capital borrowed from a broker.
To obtain a margin, an investor has to open a margin account and deposit a given minimum amount of money, which is used as collateral. This margin is called the maintenance margin. On the other hand, the amount invested in the trade is known as the initial margin.
In some circumstances, the trader may lose part of the money invested, reducing the maintenance margin. If the maintenance margin reduces beyond a certain level, the investor is supposed to top up the difference, a failure to which the broker will make a margin call.
Leveraging is the expanded ability to enlarge a trading position and increase the potential returns using borrowed capital. This is among the most utilized tools in securities markets, and it can be instituted by individual investors and corporations. However, the need for leveraging is motivated by different factors among individuals and corporations.
Usually, individual investors use leverage to optimize their profit potential, while corporations use it as a way of raising finance for their operations without re-issuing stock.
Leveraging, if not properly thought out, can lead to massive losses and even the collapse of large corporations. An example of the dangers of leverage was the 2007-2008 financial meltdown, which had several large corporations over-leveraging their positions. This is what led to the collapse of Lehman Brothers.
Leverage is simply the ratio between the amount of money you can invest and the amount you are permitted to put into a trade after obtaining the borrowed cash. For example, if you are permitted to put in $1,000 per $10 held, your leverage is expressed as 1:100. Note that the ratio applies to not only your upsides but also your downsides.
Therefore your profit will be multiplied as a factor of the leverage ratio, and the same will apply to the losses. This means that you may lose significantly larger amounts of money if the market goes against you.
Forex and securities margins
There is a significant difference in the application of margins in forex and securities markets. When it comes to securities, a margin is a down payment paid by an investor for taking stock, ETF, or bonds worth more than the amount deposited. For example, if you want to buy stock worth $2,000, you may only need to give your stockbroker $1,000.
Once you get the securities you want, you can trade them in the hope of making enough profit to repay the loan. It simply means trading with borrowed assets.
For forex margins, you need to deposit a specified sum of money with your trading platform for as long as your trading position is open. In this case, you do not borrow money but come to an agreement with the broker to buy or sell at a specified price.
The big difference between margin and leverage is that margin is the loan you obtain to trade, while leverage is the buying power you get as a result of trading in debt.
In addition, margin trading requires one to present collateral in exchange for a loan, which has to be paid back with interest. That said, there are other options that investors can employ to leverage their trading positions without having to go for margins.
Margins and leverage are essential components of securities trading. They enable investors to assume trading positions that they would otherwise not be able to take. Understanding how the components operate is key to getting borrowed assets to work in your favor. Otherwise, increased buying power may potentially translate into massive losses.