Margin and leverage are often thought to be the same thing. However, while both can be used to amplify an investor’s buying power when trading stocks, they have some key differences.
Margin trading, or “buying stocks on margin” refers to the practice of borrowing money from your brokerage and using that to purchase stocks. You are taking out a loan to purchase more of whatever stock you are trading than you would be able to with a cash account. After buying an asset on margin, you’re likely to see amplified gains or losses because of the out of pocket investment compared to a cash account, or conversely, the margin call. You will also pay interest on the amount borrowed from the broker.
Leverage is the result of using margin, but it also has a much broader meaning and usage within the world of finance. In general, it refers to the concept of using borrowed money as a source of funds for an investment. When it comes to trading, it is important to understand what your leverage ratio is so that you know the amount of risk you are taking.
We’ll explain all the details of margin vs. leverage in this article.
Leverage vs Margin
A trader uses margin to trade with leverage. A margin account allows you to have increased buying power. Leverage lets you trade bigger positions than the amount of cash in your account. Leverage and margin have an inverse relationship — the higher the margin requirement, the lower your leverage ratio will be.
You can trade stocks and ETFs on margin to make use of leverage. However, you don’t necessarily need to use margin in order to increase your leverage; there are also leveraged ETFs that effectively accomplish the same goal, that can be purchased in a cash brokerage account.
In futures trading and forex trading, brokers often allow large leverage ratios. Since the leverage ratios in these markets are greater, the risk is amplified. New traders should learn the basics of trading on margin and might consider trading a stocks and options account before venturing into the high-risk world of futures and forex trading.
Recommended: Margin Trading vs Futures: Compared and Explained
A Closer Look at Margin
Margin trading is a method by which your portfolio holdings are used as collateral to acquire a loan from a broker. Margin is the difference between an investor’s account value and the loan they request from a broker to execute a trade. An investor can use proceeds from the loan to invest in more securities like stocks, bonds, and exchange-traded funds (ETFs).
Margin trading can also allow you to diversify your portfolio with other assets without having to use more equity.
How Margin Trading Works
Margin trading works by using loan proceeds to invest in more assets. The goal is to enhance returns, but there also can be drawbacks.
Pros vs Cons of Margin Trading
| Pros | Cons |
|---|---|
| Increases buying power | Must meet and maintain margin requirements |
| Greater return potential | Higher risk than trading a cash account |
| Ability to diversify into other assets | You must pay interest on borrowed funds |
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*For full margin details, see terms.
A Closer Look at Leverage
Leverage in finance is a word used to describe borrowing money to increase returns. Investors might borrow capital from a broker or bank in order to make trades that are larger than your account’s equity, increasing your trading power. Companies might use leverage to invest in parts of their business that they hope will ultimately raise the value of the company.
How Leverage Works
Leverage in a stock account is the result of borrowing money to trade securities, using an account’s margin feature. Leverage can work to the benefit or detriment of an investor depending on the movements of an account’s holdings.
Companies often use leverage to amplify returns on their investment projects, and the same logic applies to trading equities. You may see huge returns on the upside — or see your account value drop rapidly if the market moves against you. Trading with leverage is riskier than strictly using your own cash.
Futures and forex trading often use high leverage ratios versus a stock trading account. For example, let’s say you purchased $100,000 of assets based on the value of a stock index, and posted a margin deposit of $2,000. Your leverage ratio is 50:1. If the underlying index rises 1%, your assets would increase to $101,000. Your equity would go up by 50% to $3,000.
If the trade works against you, though, your account balance would dwindle quickly. If the index falls to $99,000, your equity would be just $1,000. You might face a margin call requiring you to deposit more cash or securities.
Pros and Cons of Leverage Trading
| Pros | Cons |
|---|---|
| Potential for enhanced returns with a minimal deposit | Losses can happen fast, leading to margin calls |
| Greater access to high-priced stocks | Borrowing fees and margin interest can be costly |
| Access to many markets with limited capital | Managing multiple leveraged positions can be cumbersome |
The Takeaway
Margin trading and leverage can be used to enhance returns, but there are risks you should consider. It is important to weigh the pros and cons of both strategies to determine what trading method works best for you. Knowing the differences between margin vs. leverage is important before trading.
A margin account with stocks allows you to borrow against cash and securities when trading stocks online. Leverage measures the increase in trading power because of using margin.
It’s important to understand your personal risk tolerance before trading on margin and using leverage. Risk-averse investors might prefer a cash account; for those more comfortable with risk, trading with borrowed funds might be appealing.
If you’re ready to try your hand at options trading, a user-friendly options trading platform like SoFi’s can feel easier to navigate. Investors can trade from either the mobile app or web platform, and they can reference a library of educational content about options.
FAQ
Is leverage the same as margin?
Leverage is different from margin. You use a margin account to increase your leverage ratio when trading stocks. Futures and forex trading requires a trader to post margin to use leverage.
Can you trade without leverage?
Yes. You can trade securities with cash in your account. This method also avoids paying interest on margin balances. The downside is you will not be able to amplify returns as you would when trading on margin or with leverage.
You can also trade leveraged ETFs without a margin trading account.
What is margin in stock trading?
Margin in stock trading happens when an investor takes out a loan on an investment with the goal of seeing that asset’s price rise. When the investment is sold, the borrowed funds are returned to the lender, but you as the investor keep the profits. The downside is if the security’s price drops, you will see enhanced losses. In either event, you owe the lender interest on borrowed funds.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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