Understanding margin and leverage

Author: LegacyFX | Category: Education

Knowing more about margin and leverage in trading

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What exactly is margin trading?

Margin trading refers to trading with leverage, therefore opening up the possibility of a higher ROI. Leverage is a key forex trading term and is explained in the next section. The best part about margin trading is that while there is an opportunity to walk away with a considerable profit, the risk is reduced due to the initial investment role. Simply put, margin trading does not involve the actual purchase of financial instruments, like stocks. Instead, it is about investing a certain amount of money through a broker expecting that you will earn the same profit as from actually buying the financial instrument, without investing a huge chunk of capital.

All trading transactions are traded with a margin at most of the brokerages. Therefore, for a small amount of investment, investors obtain exposure to a larger trading position, hence generating a more significant ROI.

Leverage & margin

Leverage (aka gearing) is a key term in forex trading. It means that you invest a small sum of money as collateral to the forex broker, to earn profits implied for higher investment. Let's say a forex broker tells you that if you want to trade a standard lot of USD/EUR currency pair (equivalent to 100,000 USD), the leverage is 400:1. It means that you are expected to invest 1/400th (or 0.0025) times the actual trade volume, which is a standard lot equivalent to 100,000 USD. If you do the math, the amount of money you should be investing in is 250 USD. This amount is known as "margin." If you wanted to calculate your leverage in margin trading, all you need to do is use the simple formula below:

How exactly does it work?

The best way to understand a concept is to work through the examples.

Let's begin with the conventional trading approach. We'll assume that apple shares are trading at USD 90.00 per share. Now, let's take again that you expect the stock price to rise to USD 100.00 per share soon. Therefore, you invest your actual money in buying 200 shares of apple. So, how much money did you invest? The answer is USD 18,000.00 (USD 90.00 per share multiplied by 200 shares). When the stock price touches USD 100.00, your stocks' great value will become USD 20,000.00 (USD 100.00 per share multiplied by 200 shares). This means you earned a profit of USD 2,000.00 at the expense of investing USD 18,000.00. Your profit percentage, in this case, is 11.11%.

Now, let's take a look at margin trading. When you are trading with a margin with brokers, you don't actually buy the stocks. Instead, imagine that the broker will approach you with an offer to invest in 200 shares of apple trading at USD 90.00 per share with leverage of 10:1. What exactly does this mean? It means that you only need to invest 1/10th of the grand trade size of USD 18,000. Therefore, your margin is USD 1,800.00. If the apple stocks' price does touch USD 100 per share, then your profit will still be USD 2,000.00, as shown below:

Essentially, you end up with a profit margin of USD 2,000.00 by just investing USD 1,800.00. The profit percentage in this example is 111.11%. Compare this with the profit margin in the last scenario, and you will see how margin trading can help you obtain a higher profit percentage at a significantly lower risk.

This article was submitted by LegacyFX.
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