Margin is like a deposit or down payment for the advance you take when you trade with leverage.
When it comes to trading, the concept of margin is sometimes confused with the fee that a trader owes the broker – which is incorrect. Margin is a ‘good faith’ deposit – the collateral that is held by the broker to hold open a position. This is not a transaction cost, nor is it charged to your account, but serves to ensure that you have sufficient balance in your account relative to the size of your position.
The amount of margin that is required depends on your position size and the instrument that you are trading.
Leverage is essentially the borrowing of capital to increase your returns on investment. In the CFD industry, a broker can “lend” capital to a trader, allowing the trader to open a much larger position, just as if they had a much larger trading account than they actually do. This means, however, that a trader can also lose just as much as if they had a much larger trading account.
Brokers can afford to make this arrangement because the losses are limited to the trader’s account balance only. Once the loss exceeds the amount of money the trade has to start with, the broker will close all the trades that are currently open. This avoids the scenario where the trader has borrowed more than they have in their account and owes the broker money.
When using leverage, the capital is lent to you when you open the trade, but you do not actually see this money go into your trading account. You do, however, see the effects when your trade is open, because each pip movement has a greater value, allowing for greater potential profit or loss.
A prominent mistake that new traders make is to use leverage with no regard for the risk per trade based on their overall account balance. When there is no concern for the downside risk, leverage can destroy a trading account. Leverage and margin are not like credit cards or bank loans. They are not personalized and do not depend on your history, your account balance or your net worth. If a broker offers leverage, it is the same to all clients. The margin is preset by the broker under regulatory authority and is the same for each trader. Margin can be different on different assets or coin pairs depending on volatility and risk factors.
- leverage is the borrowing of capital to maximize profit.
- in order to use leverage, a broker requires a minimum amount of capital from the trader – this is called margin.
- different brokers offer different amount of leverage, the most common is 100:1. This means that a trader can open a standard lot with just $1,000.
- when traders use leverage without employing money management, they are in danger of losing their entire trading account.