Two concepts that are important to traders are margin and leverage. Margin is a loan extended by your broker that allows you to leverage the funds and securities in your account to enter larger trades. In order to use margin, you must open and be approved for a margin account. The loan is collateralized by the securities and cash in your margin account. The borrowed money doesn't come free, however; it has to be paid back with interest. If you are a day trader or scalper this may not be a concern; but if you are a swing trader, you can expect to pay between 5 and 10% interest on the borrowed money, or margin.
Going hand-in-hand with margin is leverage; you use margin to create leverage. Leverage is the increased buying power that is available to margin account holders. Essentially, leverage allows you to pay less than full price for a trade, giving you the ability to enter larger positions than would be possible with your account funds alone. Leverage is expressed as a ratio. A 2:1 leverage, for example, means that you would be able to hold a position that is twice the value of your trading account. If you had $25,000 in your trading account with 2:1 leverage, you would be able to purchase $50,000 worth of stock.
Not all securities are eligible for margin borrowing, and the available leverage for those that are eligible varies greatly by market. Stock traders, for example, typically utilize a 2:1 leverage. It is not uncommon, however, for forex traders to use 50:1 leverage (prior to late 2010, forex traders had access to 100:1 leverage, which many believed made it too easy to suffer catastrophic losses). While more seems better, it's important to understand that leverage magnifies both gains and losses. Here's an example:
Stock ABC is trading at $100 per share and you feel that it is poised to rise in price. With 2:1 leverage, you use the $10,000 in your trading account and $10,000 of margin from your broker to buy 200 shares of the stock (($10,000 X 2) / $100 = 200 shares). Without the margin, you would have been able to purchase only 100 shares.
Following the release of a new product and strong earnings, the stock jumps 25% to $125 per share. Your investment is now worth $25,000 and you decide to close out the position. After you pay back your broker the $10,000 you borrowed, you have $15,000 left and realize a $5,000 profit. Because of leverage, you were able to realize a 50% return on your money (less commission and interest) even though stock ABC went up only 25%.
Now assume the trade goes the other way. Instead of climbing 25%, a scandal involving the company's management causes the stock to suddenly drop 25%. With a share price of $75, your investment is now worth $15,000. You conclude that price is only going to continue dropping and decide to close out your losing position. After paying back your broker the $10,000 you borrowed, you have $5,000 left. This represents a 50% loss, not including commissions and interest. Had you not traded on margin, this would have been only a 25% loss.
While this example may not be realistic for active traders who typically seek small price moves, leverage does allow traders to make more money off smaller moves. While trading on margin and using leverage can increase your returns and allow your account to grow faster, it should always be used judiciously. It is possible to lose more than you originally invested when trading on margin.
The bottom line is trading on margin has inherent risks and may not be appropriate for everyone. You can mitigate some of those risks by using protective stop loss orders and limiting your use of leverage by not using your entire margin balance (just because you have the margin, doesn't mean you have to use all of it on any given trade). In addition, you should adequately test any trading plan before putting it in a live market and risking real money.
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