What is Leverage
For those considering investing, it’s important to first understand a
few key terms. These allow you to appreciate how the markets and
trading work, so you can form a strategy and make decisions that are
beneficial to your long-term goals.
Forming part of this core terminology are two words: margin and
leverage. “Margin” is a way for investors to increase their buying
power, which can be beneficial for those whose budgets are modest.
While it can increase profit, there’s also a greater degree of risk
inherent in it.
Perhaps you’re also wondering “what does leverage mean in trading”?
The two terms are often used interchangeably. They both refer to ways
to open a trading position with a broker using only a small amount of
capital to take up a large position.
The use of these terms can be confusing for amateur investors and
those who’ve yet to enter the markets. However, with this guide, you
should soon develop a much better understanding of them.
What is Leverage?
So, what does leverage mean? In ordinary parlance, “to leverage” is to
use something to maximum advantage. Its meaning in the financial world
is not so dissimilar: you’re taking the funds you have and using
leverage to optimise your earning potential.
If you were looking for a simplified leverage meaning or leverage
definition, you might summarise it thus: as a way to take a small
amount of money and increase its value on the investment markets.
Examples are often the easiest way to explain this kind of concept.
Imagine you have £1,000 to trade but want to increase your potential
return. You find a broker offering leverage at 25:1. With their
backing, you could manage a position of up to £25,000 by placing a
deposit of £1,000.
What is Margin?
Above, we said “leverage” and “margin” are two terms that are often
used interchangeably. This is true, but we should qualify it by
explaining that the two do have slightly different meanings.
If you’re searching for a margin meaning, this is the amount of money
you’ll need to open your position, while leverage is the multiple of
exposure. If you’d like to know how to calculate margin, work out the
size of your intended position and then divide this by the higher
number.
Lots of brokers will have a margin calculator on their page, but this
is usually easy enough to work out in your head. In the example we
used above, our hypothetical broker wanted to trade £25,000 with
leverage of 25:1. The margin formula they’d need to use would
therefore be:
£25,000 / 25 = £1,000
Equally, if the leverage was 5:1, they’d have to put down £5,000 to
manage the same size position. The formula in this instance would be:
£25,000 / 5 = £5,000
Essentially, this means you work out the margin in the following way:
Size of position / the higher figure in the ratio = the margin.
When buying on margin, the size of your deposit will depend on the
leverage offered and the trading terms supplied by the broker. This
payment is known as the “initial margin”. Margin requirements can
differ widely depending on factors like the asset type, market, and
risk involved.
How Does Margin Relate to Leverage?
We’ve largely covered this question above, but let us go into a little
more detail here. Margin is, essentially, a special type of leverage
that involves using existing cash or securities positions as
collateral. This increases the trader’s buying power.
This ability is not limitless. If traders have taken on too much risk,
brokers may put them on a margin call or implement a stop-out.
Let’s look at these two concepts individually:
Margin Call
A margin call occurs when an investor’s balance and unrealised profit
and loss are equal to their margin requirement. The broker will demand
they deposit additional funds to bring their account up to the minimum
value.
Stop-out
A stop-out, on the other hand, is the point where a trader’s equity is
equal to half their required margin. If you have trading positions
open but lack the equity to cover these, the trading platform will
automatically close them. This is implemented as part of the FCA’s
product intervention measures.
How Does Leveraging Work?
So, how does leverage work? This is a strategy that involves borrowing
funds to increase the return on investments. If the return is higher
than the interest owed, you can make a healthy profit, which is why
investors utilise it.
Using the Cash Extraction platform, you must decide whether you wish
to use leverage or not. There’s no onus on you to do so. Different
instruments will have various maximum leverage amounts. By law, these
must not exceed a certain number.
You can use a leverage multiplier to enhance your buying power. This
will often be in the form of a ratio, such as 10:1, 20:1, and so on.
This is the number of times your capital will be amplified.
If you’re wondering “what is leverage ratio” and how you calculate the
leverage ratio formula, this is easy. The smaller figure relates to
the money you put down; the larger, to how much the broker will
amplify this by. So, if the ratio is 10:1 and you deposit £1,000 in
your account, the broker will increase this amount to £10,000.
Leveraged Buyout and Stop Loss
This works in a not dissimilar way to a leveraged buyout.What is a
leveraged buyout? Where one company acquires another using a
significant amount of borrowed money. You’re essentially doing the
same to secure a larger position.