Understanding leverage, margins, and margin calls

Leverage, margins, and margin calls are all concepts related to investing in the stock market. They can be a little confusing at first, but they will help you make more informed investment decisions once you understand them.

What is leverage?

Leverage amplifies your returns on an investment by borrowing money to use as part of your initial investment, which allows you to generate much greater profits than if you were only using your own money.

For example, if you have $100 worth of capital and use it to buy stocks worth $200 when trading at $100 each, you have effectively leveraged your investment by 2x. If the price of those stocks goes up to $150 per share, you have made a 50% return on your investment. If you had only invested your own $100, you would only have made a 25% return.

Always keep in mind that leverage also amplifies your losses, and these losses can sometimes be so great they exceed your initial investment. So, if the price of those stocks had fallen to $50 per share, you would have lost 50% of your investment. If you had not used the leverage technique, you would only have lost 25%.

What is a margin?

A margin is best explained as the amount of money you must deposit to trade on margin. When you buy any stocks on margin, you are actually borrowing money from your broker to finance the purchase. The total amount of money you are allowed to borrow will depend on the Margin Ratio of your broker, which is typically around 2:1, which means that you can borrow twice as much money as the value of the stocks you are buying.

For example, let’s say that you have $100 worth of capital and want to buy shares in a company on margin. You might find that your broker requires a Margin Deposit of $50 (or 50%). So, if the share price is $100 per share, then you will be able to purchase two shares at once.

What is a margin call?

A margin call occurs when your brokerage has determined that the value of your investments has fallen below the equity balance in your account, meaning that they believe there could be a risk of significant losses on your investment.

Your broker will typically give you a set amount of time to bring your account back to the required equity balance, which can be done by either depositing more money into your account or selling some of your investments.

If you do not meet the initial margin call requirements, your broker may force you to sell some of your stocks and investments to cover the losses.

Drawbacks of leverage and margin calls

While leveragecan help you generate greater profits, they also come with several risks.

When you use leverage, you are amplifying your potential losses and your potential profits, which means that you could suffer losses if the price of the assets you have invested in falls.

Secondly, margin calls can be very stressful. If the value of your investments decreases and you receive a margin call from your broker, you will need to act quickly to meet the call’s requirements, which can be a tricky and anxiety-inducing process.

Finally, always remember that you are taking a risk when you use leverage,there is no guarantee that your investments will generate profits, so you always need to be aware of the possible downside when making investment decisions.

The bottom line

Overall, leverage, margins and margin calls can help you to maximise your returns when investing in the stock market. However, it is essential to remember that they come with some risks, so you should always be aware of the potential downsides before using them.​ We recommend using an experienced and reputable online broker such as Saxo Bank before using any of these techniques and trading on a demo account before investing your money.