These two characteristics of trading enable you to utilise your equity to its maximum. Without these, it would be near impossible to make decent returns without a huge starting bankroll. However, they are often poorly understood by traders, with disastrous consequences.
Let’s start by defining the two concepts
Margin is essentially a promised deposit – Promised meaning it is not paid upfront and deposit meaning that you must have a minimum amount of money/equity in your brokerage account.
Leverage is the ability to buy/sell a financial instrument with only a fraction of the equity, and although it is like margin it is not the same.
The difference is not important – to understand more read this. They both serve the same purpose: to give you access to more capital. This means you can trade more markets, have bigger positions and manage your risk more effectively.
Let’s imagine you have a $1000 account, and you want to buy $500 of Gold contracts. Without leverage, you would have to lock up 50% of your capital in a single position! If you traded this with x10 leverage you would only be locking up 5% of your capital. This leaves you with a lot more money to play with.
But there’s a catch. You still OWN $500 of contracts. So if this market drops 50%, you will lose 25% of your account. This is why it is so important to understand how to use a stop loss, and the importance of managing position size.
You should never think of risk in terms of leverage – leverage is simply a tool to manage your risk. This is the most common mistake people make!
Example: You want to buy gold and only RISK 2% of your $1000 account. The first step is to determine where you want your risk to be (E.g. Where is your stop loss). Imagine gold is trading at $1000, and you want your stop loss at $900 (a 10% drop). To risk your $20 (2%) you need to buy $200 of contracts. When the market drops 10% to $900, your contract will be worth $180, and hence you have lost $20.
So where does leverage come in? Well, you can buy this $200 contract in many ways. Without leverage, you could put $200 upfront and lock up 20% of your equity. But this is inefficient, and you would be limited to 5 trades at a time. Alternatively, you could use a x10 leverage (10% Margin) and put up $20 leaving you with 98% of your account left.
Your RISK is still the same, even though you have used a leverage 10 times higher. This is what people misunderstand. So the next time you ask the question ‘What leverage should I use?’, ask yourself ‘How much do I want to risk?’
The Two Traders
Read here more information about how to use leverage, or start trading now
