Margin and leverage explained
What is margin?
Trading on margin is used to increase an investor’s buying power. An investor is required to put up only a fraction of the funds they would normally need in order to open a much larger position. This means rather than paying the full value of the position, you only need to pay a percentage of the position, which is called ‘initial margin’.
Trading on margin is beneficial, but also high-risk given the fact you can potentially lose much more than the initial funds deposited into the account. Simply put, margin is the amount of money required to open a position, while leverage is the multiple of exposure to account equity. The amount of margin depends on the margin rate requirements. This differs between each trading instrument, depending on market volatility and liquidity in the underlying market.
Market volatility is the potential percentage moves of a market in a given market. Volatility is also often intricately linked to liquidity. For example, the major forex markets (US dollar, British pound, euro, Japanese yen) trade trillions per day and are considered very liquid.
The leverage ratio and margin requirements differ from broker to broker. The amounts typically offered are 50:1, 100:1 and 200:1. The leverage offered will also depend on the trade size of the position. For example, if the margin on a CFD trade is 0.02, then the margin percentage is 2%. A minimum margin requirement of 2% is the same as 50:1 leverage. A leverage ratio of 100:1 would be 1%.
NOTE: If you are new to leveraged trading, it is important that you understand the concept of margin and leverage before trading. It is also advisable to practice trading in a risk-free environment with a Palm Global demo account.
Initial Margin & Margin Requirement
Initial margin is the initial amount put up in order to open the position. It is often also referred to as an “initial deposit”. The initial margin requirements will be different for each market and differ depending on the asset type, trading instrument and intended trade size of the position.
For example: Trader ‘B’ places a CFD trade worth £2000, which has an initial margin rate of 5%. This means Trader ‘B’ is only required to deposit 5% of the total value of the position, which in this case would be £100.
What is a margin call?
When you are on margin call you are not allowed to take on any more risk, and your account is at risk of stop-out.
The point you are on margin call is when your equity (balance + unrealised profit & loss) is equal to your margin requirement. Your stop-out level is when your equity is equal to half your required margin, and your biggest losing position will be closed out forcibly. If a trader has open losing positions and does do not have enough equity to cover those positions, their account would be at risk of stop-out. This essentially means that any or all of their open positions would be automatically closed by the trading platform, if the balance dropped below the margin stop-out level.
For example: Trader ‘C’ has six open trades, each requiring £200 worth of position margin, and the current close-out percentage level on that trading account is 50%. This would make the total position margin requirement £1200. If the account of Trader ‘C’ then dropped below 50% of this total margin requirement (which in this example is £600), some or all of those trades may be automatically closed out, potentially at a loss to Trader ‘C’.
What to do if you are on margin call?
There are a two options open to a trader if they receive a margin call. The first would be to close the position there and then. The other would be to deposit additional funds to increase your equity above the margin requirement and support any further losses. If possible, you can also reduce the size of other positions to free up some further equity in the account.
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