Leverage is a trading tool that allows investors to trade contracts greater than their account balances by providing collateral, which represents a small percentage of the contract’s total value. This collateral is known as margin.
When a broker is offering leverage, this means that they are willing to execute the trades without demanding the investor to provide the full transactional value.
Leverage is usually expressed as a ratio beginning with the number one, like 1:10, 1:100, or 1:200.
What leverage of 1:100 actually means is that for every dollar the investor deposits, they can trade 100 dollars. At the same time, this same ratio is telling us that the required margin is 1%.
Let’s have an example to further understand.
Assume that an investor has opened an account with a broker that offers 1:100 leverage, and then they deposit 1,000 USD. Later, they decided to buy 800 Apple stocks at a price of USD 100 per share. In this case, the total value of this transaction is USD 80,000 (800 stocks x USD 100).
Obviously, this amount is much greater than what this investor has in their account. So, if they want to open this trade using only their own money, they will be unable to do so.
But because of the leverage offered by the broker, the investor can open this trade by providing collateral that is only 1% of its total value. That is 1% of the USD 80,000, which is only USD 800; an amount that is available in the investor’s account.
How is this leverage ratio calculated?
The ratio, or leverage size, is determined by the broker - depending on what they see as suitable for their own services. But to calculate it, we need to use two numbers:
The size of the trade
The required margin
The equation goes as follows:
Leverage = The size of the position / required margin.
So, in this example:
The leverage is calculated by dividing 80,000 over 800, which equals 100.
Thus, the broker’s leverage is 1:100.
But what is margin?
Margin is a collateral required from the trader to be able to trade larger amounts, and it can be expressed as a percentage.
Margin percentage varies from one broker to another, but the most commonly required margin ratios are 1% and 0.5%. Required margin can be as low as 0.2%, and can go up to 5% or higher. Margin requirements do not only change from one broker to another, as they can be different between various asset classes with the same broker. For example, a broker could require a margin of 1% for trading currencies, but 5% for trading stocks.
Here is an example:
Let’s say an investor is trading with a broker who requires a margin of 1% on currencies. This investor wishes to buy EUR/USD, with a contract size of 100,00 Euros.
Assuming that the investor’s account balance is USD 5,000, how will they be able to execute this trade by using margin trading?
Let’s suppose that the price of EUR/USD is 1.2100. This means that the real size of this position is 121,000 Dollars (100,000 x 1.2100). Since the broker requires a margin of 1%, then they would ask that the investor has in their account 1% of 121,000 USD, which is USD 1,210.
So, this broker will lock the USD 1,210 from the USD 5,000 capital as collateral in order to trade this position, which is worth USD 121,000.
In summary, the required margin is an amount demanded by the broker to allow you to trade a certain, much greater deal size, using leverage.
As you see, leverage and margin are two sides of the same coin.
However, investors should be aware that trading using leverage and margin is risky since they are excessively trading large amounts in the market. Although investors will be able to make larger profits, they also run the risk of making larger losses. Therefore, leverage and margin trading is known to be a double-edged sword.