What comes to mind when you hear the terms leverage and margin trading? Most people might be thinking of the same thing since they are so similar in meaning. After all, they both involve borrowing money to trade on the stock market to make a lot of profit.
However, do some more digging into the topic, and you’ll find that the two are quite different from each other. Therefore, it’s important to know their differences before taking advantage of them.
According to the experts at SoFi, “Leverage trading simply refers to purchasing securities with borrowed funds.” You can do this through margin accounts or a broker using your cash balance as collateral. In either case, you are borrowing money from your broker to buy more stock than you would otherwise be able to afford.
The margin trading is a form of trading that allows you to borrow money from your broker (also known as a margin provider) to increase your potential buying power. In other words, if you don’t have enough cash in your account to buy a stock, you can use leverage to buy it anyway.
Margin stock trading involves an interest rate and commission fees; leverage trading doesn’t. This trading method allows you to use up to 50% of your balance as collateral for a single trade, while leverage trading allows you to use up to 50% of your margin account balance as collateral for a single trade.
When you’re trading on margin, you can lock in costs for two weeks of trading at a time. This is great if you don’t want to worry about daily fluctuations in price, but it also means that your trades are less liquid than they would be otherwise.
You can trade a larger position than your account balance would normally allow when you’re trading on leverage. This is great if you want to take advantage of price swings without paying for them in cash upfront.
If a 1% move in price happens on 100 shares of ABC, you would have lost $10.00 on a margin trade and only $1.00 on a leveraged trade. This is because you borrow money from your broker (margin), which magnifies both gains and losses.
If you open a leveraged position and lose money, your margin balance might fall below your maintenance level. For example, if you hold a 5x leveraged position worth $1,000 but only have $600 in margin funds, you’ll be placed on a 60% maintenance margin rate.
Your position will be liquidated if you can’t bring your balance back up. Liquidation occurs when your account balance is lower than your maintenance margin threshold (or maintenance margin rate).
To trade on margin, you must be a client of a brokerage firm that offers margin stock trading. In addition, you must have a minimum amount of equity in your account. This is known as your maintenance requirement, and it varies from broker to broker.
Anyone can trade on leverage, and there are no minimum requirements. All you need is a trading account and an online brokerage account.
Liquidity risk measures how much slippage you could face in an attempt to trade on a position or transfer an asset.
Unlike margin buying and trading, leverage trading is limited in many markets. For example, on Euronext and NYSE Liffeexchanges, leverage is capped at 50:1 while Nasdaq sets a maximum of 100:1.
Although margin trades can magnify your gains and losses, it also increases your counterparty risk. On the other hand, Leverage counterparty risk is much lower than that of Margin counterparties. In a leveraged trade, you are only required to put up a fraction of what you are buying or selling as collateral for your trade.
In short, leverage trading allows you to increase your buying power. However, margin stock trading is riskier and can lead to bigger losses if used incorrectly. Therefore, investors must understand both before deciding which one they want to use for their investment strategy.