Leverage and margin are concepts that every self-respecting trader, whether fundamental or technical, must know and understand. They are the base of account management. Let’s get started.
What is Leverage?
Leverage is a tool that allows traders to control a large amount of capital with a relatively small deposit. The term is quite literally derived from lever, which allows a user to lift heavy objects by using a very small amount of force, compared to when not using a lever.
Unlike traditional investing, where the full value of a position must be paid upfront, leveraged trading requires only a fraction of the position’s value, known as margin. For instance, with 1:100 leverage, you can control a position worth $100 with just $1. This feature has made markets like forex and commodities more accessible to retail traders who prefer not to allocate significant capital to each trade. However, leverage magnifies both the traders’ profits as well as losses, so it must be used carefully.
What is Margin?
Margin is the capital required to open a leveraged trade. Different markets have varying margin requirements. For example, you might need to pay 20% of a stock position’s value, whereas in forex trading, the margin could be as low as 5%.
Here is an example of how it works in practice:
In Share Investing, If you buy 1,000 shares of company ABC at $5.00 per share, the total value of your investment is $5000. Since you’re purchasing the shares outright, you need to pay the full amount upfront.
If the share price increases to$5.25, selling your shares yields $5,250, resulting in a $250 profit. This represents a 5% return on your $5,000 investment. If the share price drops to $4.75, selling your shares would result in a $250 loss, equating to a 5% decrease in your investment.
Now let’s assume you are trading at 1:5 leverage, which equates to 20% margin requirement. If you buy 1,000 share CFDs of company ABC at $5.00, you only need to deposit $1,000 to open the position, instead of the full $5,000.
If the share price rises to $5.25 you can sell your CFDs for a $250 gain. This represents a 25% return on your $1,000 investment. Conversely, if the share price falls to $4.75, you would lose $250, which is a 20% loss on your investment.
As illustrated, margin trading can amplify both gains and losses. Effective risk management strategies, including the use of stop-loss orders, are essential when using leverage.
Margin Calls
Maintaining sufficient margin in your account to cover your open trades is crucial. If your account balance falls below the required margin, you may face a margin call. This puts your positions at risk of being closed out automatically.
In Prop Trading, however you might not receive margin calls, since stricter risk management is required on your side. You will always be required to keep your account above the daily and maximum loss limits to keep your positions and your account open.
Overnight Financing
Overnight financing covers the cost of leverage. Depending on the formula and underlying interest rates (or rates differential when it comes to currency trading), the overnight charge is either debited or credited to your account. For example, if the FED interest rate is 3%, a possible calculation for the overnight charge for long positions may be:
(Position size * (FED rate + 2.5%)) / 365
In our ABC example, 1000 shares valued at $5.00 per share at market close are worth $5,000. The charge will then be ($5,000 * (3% + 2.5%)) / 365) = $262.5 / 365 = $0.72 daily charge.
For short positions the reverse will apply, were 2.5% are subtracted from the FED rate: ($5,000 * (3% – 2.5%)) / 365) = $25 / 365 = $0.07 daily charge
For further reading you can visit our FPT Trading Academy.
