Imagine yourself to be a market investor, and your analysis about a particular ABC stock says the price is likely to hike in the next couple of days. Sure, you want to invest, but what do you do if you have insufficient funds for the transaction? This is where Margins and Leverages come to play! Margins and Leverages assist you in creating income when you are short of funds.
What is Margin?
Margin is used to enhance an investor’s buying power. Trading on Margin is fruitful but at the same time also high-risk because you can probably lose your entire investment. An investor needs to put in a fraction of the amount to hold a larger position. Meaning, that instead of paying the total value to hold the place, the investor only needs to pay a percentage called “initial margin.” Professional or retail clients can lose more than their deposits, meaning they will have to deposit additional funds to cover losses.
For Example– You are looking to buy shares worth Rs 50,000 of XYZ Company, and you are short of funds. In this case, you will pay a fraction (assume 10%) of the total amount, which is Rs 5000. The broker will pay the remaining amount. The sum of Rs 5000 is termed as Initial Margin.
Margin is placing your assets as collateral with the broker to request a loan for trading activities.
What is the Minimum Margin?
Trading in Margin requires the investor to open a Margin Account with a specified sum as collateral. This fixed sum is called Minimum Margin. However, the total sum in the account should not cross the set limit. The margin amount is not independent of the margin rate requirements, which differ between each trading instrument, depending on market volatility and liquidity.
What is Leverage?
Margin enables an investor to open a position or an equity account; however, leverage helps you increase your purchasing power. Leverage involves using different techniques and tactics that ultimately focus on getting better returns.
For example: Assume you want to purchase the shares of XYZ Ltd, currently trading at Rs 500. Instead of paying the total amount, you can use the leverage. Then, you as an investor will be paying only a fraction of the amount, say Rs 100. The broker will pay the rest. Thus, an increase in price by Rs 100 will bring a gain of Rs 500. However, the gain would have been Rs 100 only if you paid the entire amount.
Higher Leverage = Higher Risk.
The leverage ratio and margin requirements vary from broker to broker but are ideally offered in 10:1, 20:1, and 30:1 ratios. The leverage provided also depends on the trade size of the position. A leverage ratio of 20:1 means the minimum margin requirement is 5%. A minimum margin requirement of 10% would be a 10:1 leverage ratio.
What is a margin call?
A margin call is when you are not allowed to take a different risk, and your account itself runs a risk of stop-out. A margin call is a point when your equity is equivalent to your margin requirement. The stop-out level is when the equity equals half the required Margin, and the biggest losing position will be forcibly closed.
For Example– A Trader has five open trades, and each requires Rs 2000 worth of position margin. The close-out percentage level is 50% on the trading account. This means that the total position margin requirement is Rs 10,000. If the total margin requirement drops below Rs 5000, either some or all of the trades will automatically close out, leading to a potential loss for the trader.
What are the options when on a margin call?
There are just two options open to any trader if they receive a margin call.
- Close the position then and there.
- Deposit extra funds to increase the equity above the margin requirement. Additionally, one can reduce the size of the positions to free up some equity in the account.
Difference between Margin and Leverage
Margin lays the foundation for undertaking leverage in a market. The brokerage firms typically fix the rates for both Margin and Leverage. However, here are a couple of differences between the two:
- Margin is usually the percentage of deposit required, while leverage is mentioned through a ratio.
- Margin is typically associated with futures and options. However, leverage is used for CFD (Contract for Difference) or spread betting.
- The two are interrelated; however, Margin enables one to leverage, involving different tactics that may not involve a margin account.
Margin is the amount of money required to open a position, and Leverage is the multiple of exposure to account equity.
Are Margin and Leverage meant for you?
Leverage enables you to utilize your capital’s full capacity and power, exposing you to different securities. These result in more profit that is often multiplied by n number of times. With so much reward comes a considerable amount of risk, which is the obligatory amount you may have to pay the broker in case you incur a loss.
Also, if your investment portfolio does not require margins or leverage, it is best to keep away. If your financial goals align to use Margin, only then is it a good idea. However, never lose track of the risk associated with the same.
Act of margin trading and leverage is a game of effective manipulation, with powers to turntables and probe you from your detrimental goals. Unless one is sure to nail the trade, it is best not to spend money you do not own. Also, if you are new to trading, it is best not to jump into margin trading and leverage. Understand and analyze the market and be well equipped with the proper knowledge before looking into margin trading and leveraging.
Also, check what type of account is allowance for doubtful accounts.