Difference Between Margin Trading and Leverage

Last Updated: 24 Aug 2023

If you that the entire margin trading vs leverage debate was the same, there is a subtle difference. When you want to stretch your purchasing power with margin funding or any other borrowing, that is called leverage. At the outset, margin funding is a form of leverage, but the only difference is that it is not a committed loan. In margin funding, your margin funding account works like an overdraft account in a bank wherein you only pay interest on the number of funds utilized. In the margin trading parlance, it is the debit to the margin account that is classified as a loan. To that extent, it is not a binding commitment like the leverage of a loan and that is how the margin trading vs leverage argument is tweaked.

When you get into equity investing, there is tremendous potential for above-market returns in certain unique situations. However, such situations may require that you commit more capital. In such cases, instead of missing out on the opportunity, you can opt to borrow money from a broker or other entity to gain enough capital for the investment plan. The broker asks for some assurance that the investor will be able to pay back the borrowed sum with interest in case the trade goes south, and that comes in the form of your margin as well as the collateral offering of shares.

Margin Trading and Leverage

Margin is the total amount invested by you including the cash brought in, the funds borrowed, and the collateral value of the shares / other securities offered by you. The inclusive amount is referred to as the margin and this practice generates a degree of trading power referred to as leverage. In other words, let us put it this way. Margin trading can be used to generate leverage and is one of the methods or techniques of generating leverage in the capital markets. Leverage is nothing but the ability to amplify portfolio/trading performance.

Of course, leverage intends to magnify the profits but this comes with the inherent risk that even losses could get magnified in the process. We now get deeper into the margin trading vs leverage debate and while the two do appear to be similar at first, we will look at the subtle differences between the two. Here is a quick look at the margin trading vs leverage debate.

One important point, to sum up, is that conservative leverage strategies over long periods tend to reduce risks better. On the other hand, short-term investments on margins tend to yield good results in markets with high liquidity and the midst of opportunities.

1. Let us understand the practice of margin trading and leverage. Margin trading is the practice of using assets owned by a trader/investor as collateral for soliciting a loan from a broker. The loan thus received is used to carry out trades. Leverage is the practice of using borrowed capital to carry out a trading endeavor to amplify its potential returns to a higher level with the help of debt or quasi debt.
2. Margins trading work like an overdraft facility in the sense that it can generally be defined as the difference or the gap between the total value of securities lying in a person’s margin account and the loan amount required from a broker to carry out the trade. It is the net figure and maybe negative (loan) or positive (surplus). Leverage, on the other hand, can be logically employed by individual investors as well as by institutions and corporations to serve different sets of needs. Investors normally tend to leverage trades to increase their effective returns, net of interest costs through options, futures, or margin accounts, financing assets through debt. The idea here is that leverage enables the company in question to increase equity valuations and avoid having to issue new stock. So, you can understand leverage as the ratio of the amount of money you are allowed to invest and the amount you are allowed to trade in after taking on debt. In short, if you are allowed to invest in the market up to Rs.500,000 on a margin of Rs.100,000, it is considered to be a leverage of 5 times. This leverage is the extent or proportion to which the potential profits and losses get magnified.
3. To be able to buy on margin under the margin trading facility, it is essential to open a margin trading account with a base minimum margin or sum as an initial investment. This sum acts as the comfort level for the financer, and this margin can be offered either in the form of cash or in the form of stock collateral. Concerning leverage, it can be used in the context of equity or even futures trading, options trading, commodities trading, or even currencies trading. Leverage is most often used to indicate the degree or the extent of buying power afforded to the said trader by taking on debt.
4. There are two important aspects of margin account you need to know. For example, the sum you invest in the trade and the amount of money that has to be kept in the margin account as collateral while trading is alternatively known as the initial margin and maintenance margins respectively. Like margin trading, leverage also involves borrowing and shows the extent to which the resources can be leveraged for higher limits.
5. In margin trading, in case the balance in the margin trading account falls below the maintenance margin level, there are two options in front of the margin trader. Against the margin call, the trader can either bring in additional margins to replenish the margin trading account or allow the position to be reversed to recover the losses. Leverage is normally the risk in margin trading.

Leverage Strategies

Leverage strategies can be used in any of the above ways.

• Using trading leeway as leverage for intraday trading. This is done through intraday margins to enhance positions.
• Using the margin trading facility to enhance your capacity to buy stocks by taking short-term debt to enhance returns and ROI in the process.
• Using long futures and short futures as a proxy for leverage in the stock markets to enhance position size as a percentage of margin provided.
• Using long options as a proxy via calls and puts can be used for long and short positions in the market respectively via payment of premium margins

How to Calculate Leverage?

Leverage can be seen as the ratio of the actual position taken to the margin provided. This is the standard formula for all types of leverage. Leverage must also be understood concerning risk.