PRINCIPLES OF TRADING: LEVERAGE AND MARGIN
All novice and seasoned traders need to befriend these two great tools to achieve success in trading: leverage and margin.
Leverage is the utilization of various financial instruments to increase buying power and return of an investment. It enables anyone to pay less than a trade’s full price to enter larger positions. On the other hand, margin refers to the borrowed money used for purchasing securities.
In equity trading, not all securities are suitable for margin borrowing, and each market has its own criteria for using leverage. For example, in forex, currency traders typically use a leverage of 100:1 or even higher. Leverage is a two-edged sword because it can either bolster gains or worsen losses. Here’s how.
Trader B presumes Apple shares, which is trading at $100 a share, will decline and that the stock will continue to slide. So he decided to close out his position. The trader has $10,000 in his trading account and $10,000 of margin. Using a leverage of 2:1, Trader B bought 200 Apple shares.
True enough, the stock dropped to $70 a share because of lower than expected revenues. Trader B reaped $14,000 from that losing trade. After returning the $10,000 he borrowed from his broker, Trader B has $4,000 left.
Let’s assume Trader A has Apple holdings, in which the stock trades at $80 a share. The trader believes the stock price will soar. He has $10,000 in his trading account, as well as $10,000 of margin and used a leverage of 2:1 to purchase 300 Apple stocks. So, Trader A decided to close out his position.
The tech giant released Apple Watch and its stock climbs to $100 a share. Trader A generated $30,000 from that winning trade. After deducting the $10,000 he borrowed from his broker, he has $20,000 left and gained a $5,000 profit.
Trading on leverage and margin allows a trading account to grow faster and can bolster returns. However, proceed with caution. While losing positions are inevitable, one can put stop loss orders and curbing the usage of leverage to alleviate some of the risks.
We shall cover the most popular trading instruments in the next session.
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