Leverage and margin

In this article, Psi Markets will introduce the concepts of margin and leverage.

What is leverage?

The word “leverage” comes from the word “leverage”. A lever is a mechanical instrument that allows you to lift or move a large object by applying a small force. Similarly, leverage gives the investor the ability to control a large investment with a small deposit.

In essence, leverage is capital that the broker lends to you, the investor. The factor by which your exposure (the actual value of your position) is compared to your deposit, is the leverage ratio. The exact ratio varies, but is often a factor of 2, 5, 10 or 20. It depends on the derivative being traded, the type of account you have and the position you are running.

Depending on the electronic trading platform and broker, commissions or fees may be charged on leverage and trading. There is also a spread that applies to all investments of this type. The spread is the difference between the market price and the price you receive. Some brokers replace commissions with a fixed spread.

Leverage is a universal feature of CFD (Contracts for Difference) trading. With the same margin, CFD allows you to have unprecedented exposure within the market, while increasing your risk and reward. Remember that leverage is the initial deposit required to enter a market position, but you remain responsible for the entire value of the exposure if the market moves in the wrong direction.

What is margin?

The initial deposit that generates leverage is called margin. Margin varies for each instrument you trade.

For example, let’s say you have 1,000 dollars in your account. You can buy CFDs on a USD-EUR quote for a margin of $700 and use the remaining $300 to buy a CFD on a stock listed on the NYSE.

(Note that we have removed any commission, spread or fee to simplify the calculation).

The advantages of margin and leverage

Margin and leverage are powerful tools that, if used carefully and intelligently, allow small investors to achieve large returns on their investments.

Naturally, the primary objective is to maximize your profits. With leverage, investors enter into positions that are many times larger than their initial deposit. If the price moves in a favorable direction, your earnings will be equivalent to what they would have been if you had invested the full amount.

Therefore, leveraged trading allows for broader machination of your investments. An investor who allocates smaller amounts to leveraged trades gains the ability to trade more frequently and in a more varied manner than he or she would otherwise be able to.

The Disadvantages of Margin and Leverage

While the big attraction of using leveraged products is their profit-maximizing potential, they also carry certain dangers.

A common side effect of leverage is that the small initial deposit gives the investor a psychological illusion of security. They end up exceeding the liability limits covered by your deposit.

Remember that moving prices in the wrong direction will increase your losses. Although your margin is small, your exposure is the same size as it would be if you had invested the full amount. This situation can lead to a margin call, which occurs when your losses exceed the limit pre-established by your broker.

Payment must be made promptly after the margin call is issued, and you may have to withdraw money from other investments to avoid default.

Investors who have traded in the stock market will likely miss their shareholder privileges when trading leveraged products. Furthermore, dividends that would otherwise benefit investors will work against you if you have been left in a bad position in a particular stock.

Always keep in mind that there may be fees and charges associated with leveraged products that you may not have encountered before in other investments. Overnight position maintenance charges, insurance deposits, larger-than-expected bid/ask spreads, and interest on margin can cut into your profits.