One of the secrets to wealth is the use of leverage. In short, the principle of leverage, as applied to making money, is to use a small amount of money to control a large asset.
Here, you explore leverage and how it relates to and differs from the margin made available to you by your brokerage firm.
Leverage: A double-edged sword in the battle for wealth
A common example of using leverage is when you buy real estate. You’re able to control an expensive piece of property with a small down payment.
Because you’re investing only a small amount of your own money, you’re able to use the balance of your remaining cash to invest in other financial vehicles and, thereby, expand the interests of your investments far beyond what you could if you had to pay the full amount for each investment.
It’s similar in the trading world. For example, you can trade futures and forex because they often give 20-to-1 or even 50-to-1 leverage. Controlling a large amount of money by investing only a small amount of money allows you to make more money faster.
As an example, if you place an order for one lot on a forex pair that’s worth $100,000, you may be able to open that order by investing only $2,000; however, you can make money based on the $100,000 value of the currency pair.
On the other hand, you can also lose the amount of money based on the $100,000 value of the currency pair! That’s exactly what the saying, “Leverage is a double-edged sword,” means.
Margin: The requirements for the privilege of using leverage
In keeping with the comparison to buying a house using a mortgage, to open a leveraged position in the market, you’re required to make a down payment. Brokerage firms operate a little differently than buying a house in that you’re not actually putting down a small percentage of the value of the real estate to one day own it.
When trading, you put up a percentage of the financial vehicle’s value to control the full value you’re buying. This is called margin, which functions as a “good faith deposit.” The margin requirement is the amount of money a trader is required to have in his account to control a certain order size. It’s based on a percentage of the value of the entire order.
With stocks, the margin requirement is typically 50 percent (or 25 percent for qualified day traders). With futures, the margin requirement is often around 5 percent. With spot forex, the margin requirement is at most 2 percent in the United States (and can be lower in other countries).
If you’re losing money and the value of your open positions (the money you still have invested in the market) goes below your margin requirement, you may receive a margin call. When this occurs, your broker will typically close the position you have open in the market unless you add more funds to your account.
Leveraged investments can be riskier than those that aren’t leveraged because the balance of the money you’re controlling, minus your “down payment” (margin), is borrowed money. If the market were to tumble catastrophically, beyond your down payment, you’d owe the full amount (plus potential interest on the borrowed money).
Be sure to talk to your broker and ask about your maximum risk exposure based on your account. Some brokers offer technology that attempts to limit your maximum loss to the funds in your brokerage account.