What is Leverage
For those considering investing, it’s important to first understand a few key terms. These allow
you to appreciate how the markets and trading work, so you can form a strategy and make decisions
that are beneficial to your long-term goals.
Forming part of this core terminology are two words: margin and leverage. “Margin” is a way for
investors to increase their buying power, which can be beneficial for those whose budgets are
modest. While it can increase profit, there’s also a greater degree of risk inherent in it.
Perhaps you’re also wondering “what does leverage mean in trading”? The two terms are often used
interchangeably. They both refer to ways to open a trading position with a broker using only a small
amount of capital to take up a large position.
The use of these terms can be confusing for amateur investors and those who’ve yet to enter the
markets. However, with this guide, you should soon develop a much better understanding of them.
What is Leverage?
So, what does leverage mean? In ordinary parlance, “to leverage” is to use something to maximum
advantage. Its meaning in the financial world is not so dissimilar: you’re taking the funds you have
and using leverage to optimise your earning potential.
If you were looking for a simplified leverage meaning or leverage definition, you might summarise
it thus: as a way to take a small amount of money and increase its value on the investment markets.
Examples are often the easiest way to explain this kind of concept. Imagine you have £1,000 to
trade but want to increase your potential return. You find a broker offering leverage at 25:1. With
their backing, you could manage a position of up to £25,000 by placing a deposit of £1,000.
What is Margin?
Above, we said “leverage” and “margin” are two terms that are often used interchangeably. This is
true, but we should qualify it by explaining that the two do have slightly different meanings.
If you’re searching for a margin meaning, this is the amount of money you’ll need to open your
position, while leverage is the multiple of exposure. If you’d like to know how to calculate margin,
work out the size of your intended position and then divide this by the higher number.
Lots of brokers will have a margin calculator on their page, but this is usually easy enough to
work out in your head. In the example we used above, our hypothetical broker wanted to trade £25,000
with leverage of 25:1. The margin formula they’d need to use would therefore be:
£25,000 / 25 = £1,000
Equally, if the leverage was 5:1, they’d have to put down £5,000 to manage the same size position.
The formula in this instance would be:
£25,000 / 5 = £5,000
Essentially, this means you work out the margin in the following way:
Size of position / the higher figure in the ratio = the margin.
When buying on margin, the size of your deposit will depend on the leverage offered and the trading
terms supplied by the broker. This payment is known as the “initial margin”. Margin requirements can
differ widely depending on factors like the asset type, market, and risk involved.
How Does Margin Relate to Leverage?
We’ve largely covered this question above, but let us go into a little more detail here. Margin is,
essentially, a special type of leverage that involves using existing cash or securities positions as
collateral. This increases the trader’s buying power.
This ability is not limitless. If traders have taken on too much risk, brokers may put them on a
margin call or implement a stop-out.
Let’s look at these two concepts individually:
Margin Call
A margin call occurs when an investor’s balance and unrealised profit and loss are equal to their
margin requirement. The broker will demand they deposit additional funds to bring their account up
to the minimum value.
Stop-out
A stop-out, on the other hand, is the point where a trader’s equity is equal to half their required
margin. If you have trading positions open but lack the equity to cover these, the trading platform
will automatically close them. This is implemented as part of the FCA’s product intervention
measures.
How Does Leveraging Work?
So, how does leverage work? This is a strategy that involves borrowing funds to increase the return
on investments. If the return is higher than the interest owed, you can make a healthy profit, which
is why investors utilise it.
Using the SummitTrading platform, you must decide whether you wish to use leverage or not.
There’s no onus on you to do so. Different instruments will have various maximum leverage amounts.
By law, these must not exceed a certain number.
You can use a leverage multiplier to enhance your buying power. This will often be in the form of a
ratio, such as 10:1, 20:1, and so on. This is the number of times your capital will be amplified.
If you’re wondering “what is leverage ratio” and how you calculate the leverage ratio formula, this
is easy. The smaller figure relates to the money you put down; the larger, to how much the broker
will amplify this by. So, if the ratio is 10:1 and you deposit £1,000 in your account, the broker
will increase this amount to £10,000.
Leveraged Buyout and Stop Loss
This works in a not dissimilar way to a leveraged buyout.What is a leveraged buyout? Where one
company acquires another using a significant amount of borrowed money. You’re essentially doing the
same to secure a larger position.
