MARGIN AND LEVERAGE
What Exactly Is Margin Trading?
Margin Trading refers to trading with leverage, therefore opening up the possibility of a higher ROI. Leverage is a key Forex trading term and is explained in the next section. The best part about margin trading, is that while there is an opportunity to walk away with a huge profit, risk is reduced due to the role of the initial investment. Simply put, margin trading does not involve the actual purchase of financial instruments, like stocks. Instead, it is about investing a certain amount of money through a broker with the expectation that you will earn the same profit as from actually buying the financial instrument, without investing in a huge chunk of capital.
All trading translations at CMSTrader are traded with a margin. Therefore, for a small amount of investment, investors obtain exposure to a larger trading position,hence generating the possibility of earning a greater ROI.
Leverage & Margin
Leverage (aka gearing) is a key term in Forex trading. It basically means that you are investing a small sum of money as collateral to the Forex broker, in order to earn profits meant for higher investment. Let’s say a Forex broker tells you that if you want to trade a standard lot of USD/EUR currency pair (equivalent to USD 100,000), the leverage is 400:1. What it really means is that, you are expected to invest 1/400th (or 0.0025) times the actual volume of trade, which in this case is a standard lot equivalent to USD 100,000. If you do the math, the amount of money you should be investing is USD 250. This amount is known as “margin”. If you wanted to calculate your leverage in margin trading, all you need to do is to use the simple formula below:
How Exactly Does It Work?
The best way to understand a concept is to work through the examples.
Let’s begin with conventional trading approach. We’ll assume that Apple® shares are trading at USD 90.00 per share. Now, let’s assume again that you expect the stock price to rise to USD 100.00 per share in the near future. Therefore, you invest your actual money in buying 200 shares of Apple®. So, how much money did you invest? The answer is USD 18,000.00 (USD 90.00 per share multiplied by 200 shares). When the stock price touches USD 100.00, the grand value of your stocks will become USD 20,000.00 (USD 100.00 per share multiplied by 200 shares). This means you earned a profit of USD 2,000.00 at the expense of investing USD 18,000.00. Your profit percentage in this case is 11.11%.
Now, let’s take a look at margin trading. When you are trading with margin with brokers, you don’t actually buy the stocks. Rather, imagine that the broker will approach you with an offer that you can invest in 200 shares of Apple® trading at USD 90.00 per share with a leverage of 10:1. What exactly does this mean? It means that you only need to invest 1/10th of the grand trade size of USD 18,000. Therefore, your margin is USD 1,800.00. If the price of the Apple Stocks does touch USD 100 per share then, your profit will still be USD 2,000.00 as shown below:
Essentially, you end up with a profit margin of USD 2,000.00 by just investing USD 1,800.00. The profit percentage in this example is 111.11%. Compare this with the profit margin in the last scenario, and you will see how margin trading can help you obtain a higher profit percentage at a significantly lower risk.