MARGIN AND LEVERAGE
What Is Margin Trading?
To understand margin trading, you need to understand leverage. Margin trading means using leverage, which increases the likelihood of securing a higher return on investment.
Advantages of Margin Trading
Higher profits are one of the biggest advantages of margin trading. Another advantage is that even with a loss making trade, that loss is limited to a trader’s initial investment only. It’s not too good to be true. Millions of traders trade with leverage every day with brokers around the world. The only thing that separates margin traders in terms of profits is the amount of leverage used.
Understanding Leverage and Margin
is a fundamental concept in Forex trading. It means that a trader
invests a small sum of money as collateral with a broker in the hope
of earning a higher profit when the trade is successful.
Let’s say a Forex broker tells you that if you want to trade a standard lot of crude oil (equivalent to 1000 barrels), the leverage is 500:1. Lets assume the market price of crude oil is USD 100 per barrel. This means that the market price of a standard lot of crude oil will be USD 100,000. However, since you are trading with a leverage of 500:1, you are only required to pay 1/500th of the total investment. In other words, you only have to invest USD 200. The amount that you actually invest is known as margin. In this case, the margin is USD 200.
Conventional Trading vs. Margin Trading
Let's assume that Microsoft® shares are trading at USD 20 per share. If you want to purchase 100 shares of Microsoft®, you invest USD 2,000. Now, if the price of Microsoft® shares rises to USD 25 per share in the future, you will be able to sell the 100 shares at USD 2,500. Essentially, you make a profit of USD 500. Your profit margin is 25% because you've made USD 500 profit with an investment of USD 2,000. The important thing to note here is that when you purchased the stocks for Microsoft®, you actually owned the stocks. This does not apply to margin trading.
When you are trading with margin with a broker, you are taking a position on the rise or fall of a stock price, and you do not actually purchase the stocks. So, imagine that the broker gives you an offer of investing in margin trading at a leverage of 50:1 for 100 shares of Microsoft®. This means that the broker expects you to pay 1/50th of the total amount for 100 shares. In this case, it will be 1/50th of USD 2,000 - which is USD 40. Now, when the price of Microsoft® stock touches USD 25 per share, your profit will still be USD 500 as in the last case. What does this mean? This means that you earn a profit of USD 500 by investing just USD 40! What is your profit percentage? The profit percentage is a staggering 1250%. In real life, the leverage may vary depending on the kind of broker you are using. However, the concept remains the same. Do the math and see that margin trading is better than conventional trading in so many ways.