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Difference Between Margin Trading and Leverage

10 Aug 2023

Introduction

  • Margin trading and leverage are often mistaken for the same concept. However, they share a key distinction.
  • Traders utilize margin to deal with leverage and increase their buying power. Whereas leverage enables them to trade for larger positions than the cash they have.
  • Thus, the higher the margin requirement, the lower the leverage ratio will be.

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What is Margin Trading?

  • Margin trading involves mortgaging assets to secure a loan from a broker. This enables individuals to engage in trading activities.
  • The margin represents the difference between an individual's total securities value within their margin account and the loan amount provided by the broker for trading purposes.
  • It starts with an initial investment known as 'minimum margin' and maintains collateral during trading that is called 'initial' and 'maintenance' margins.
  • Falling below the maintenance margin triggers brokers to enforce margin calls like prompting a deposit, loan repayment, or investment liquidation.
  • Margin trading is a complex interplay between assets, loans, and collateral.
  • It requires careful consideration of financial positions to avoid margin calls.

What is Leverage?

  • Leverage refers to utilizing borrowed capital to enhance potential returns. Investors and companies adopt this technique for different goals.
  • Investors leverage trades for higher returns via options, futures, or margin accounts.
  • Companies use leverage to finance assets through debt, bolster equity values, and avoid issuing new stock.
  • Leverage signifies the invested-to-borrowed money ratio. For instance, a 1:100 leverage allows trading of Rs. 100,000 for every Rs. 1,000 invested.
  • However, leverage heightens potential losses by risking a larger portion of borrowed funds compared to personal investment if a trade goes awry.

What are the Differences Between Margin Trading and Leverage?

  • Both margin trading and leverage aim to bolster purchasing potential via borrowing.
  • While leverage encompasses various methods, including margin funding, margin funding operates like an overdraft account, incurring interest solely on used funds.
  • Margin trading designates the margin account debit as a loan, yet it lacks the rigid commitment of conventional leverage.
  • Equity investment amplifies potential returns, especially in unique scenarios. Such opportunities may necessitate an increased capital commitment.
  • To seize these prospects without capital constraints, investors can borrow from brokers or entities, leveraging their margins and sharing collateral.
  • Brokers seek assurance of repayment, ensuring interest coverage in adverse trade outcomes. This interplay underscores the nuanced relationship between margin, leverage, and investment optimization.
  • Trading stocks and ETFs with margin offers leverage, but it can also be achieved through other means, like leveraged ETFs in cash brokerage accounts.
  • Futures and forex trading provide substantial leverage ratios but also intensify the risks.
  • Newcomers should grasp margin trading fundamentals and start with stocks and options accounts before delving into the riskier domain of futures and forex trading.

 

Related Articles: Difference Between Blue and Red Ocean Strategies | What is Evening Star Candlestick Pattern | Difference Between Margin Trading And Short Selling | What is trading on equity

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