Getting initiated into the world of online trading requires, at first, understanding how the industry functions, as well as a series of terms that traders often encounter throughout their journey. Out of this vast terminology base, margin and leverage stand out because of their importance.
It is very likely that you’ve heard in the media that trading on margin reached a new record level in 2021. What does this mean? How can margin and leverage influence your trading performance? The answers to these and other questions will be provided here.
Why margin trading?
To make things simple, experts working at Trustpac provide some insightful knowledge, so beginners can grasp these terms easier.
“Back in the day, trading in the financial markets was not as accessible as today, mainly because it required a large amount of capital to open even the smallest trade. As interest rates continued to decline and with advanced technology emerging, margin trading was designed. The “margin” represents the funds you deposit in a trading account, using it to buy or sell different assets.”
It can also be called collateral because that’s the liquidity you are committing to make purchases or sales. Using that margin, retail brokerages such as Trustpac facilitate traders to use leverage, which is basically your ability to trade on sums larger than your deposit.
Using leverage while trading basically means that your broker lends you liquidity so it’s possible to place trades worth more than the account margin. A leverage set at 1:100, for example, means that for every unit of currency you commit, the broker will lend you 99 units.
Put differently, you will have a 1% margin requirement. In case the leverage is 1:50, for every unit you commit, the broker will lend you 49 units. In this case, the margin requirement is 2% of the transaction value.
Difference between margin and leverage
Having said all of that, it’s easy to understand that margin represents cash in your trading account, while leverage is a feature that allows you to borrow against it, in order to gain a larger exposure in the market.
Margin trading is one of the main reasons why online trading managed to grant access to the markets to a really wide population. However, as most trading educational resources highlight, it should be used responsibly, taking into account risk management rules.
That’s also the reason why brokerages set different margin requirements, depending on the asset class. Stocks and cryptocurrencies, for instance, are volatile assets and because of that, the maximum leverage is low and margin requirements higher, compared to other assets like currency pairs.
All beginners need to understand that margin and leverage are concepts set up to assist in improving trading performance over time. It’s not enough to know the technicalities around these terms. Traders must also be aware of the risks associated with margin and leverage, and how to negate or minimize them.