Credit financing is here to stay. This is a corporate part of the present-day society. Now we live with an auto in a bank credit, iPhone on deferred terms, a mortgaged flat. Not all people are able to pay in full if an amount is large. It is much more convenient to pay by instalments. Today, you can buy almost anything, even securities, on credit. What is credit financing at the stock exchange? And can you benefit from a leverage option? Let’s discuss the issues.
Definition and concept of leverage
Those days when only rich people could trade on the stock exchange are long gone. Today, you can start having only 100 dollars on your deposit account. That is possible thanks to margin trading. Margin lending or the so-called leverage is a tool that allows carrying out transactions on the stock exchange even with a minimum deposit. You can borrow an amount, you need, from a broker. In other words, this is a usage of borrowed money aimed at an increase of volume of trades and as a result aimed at a boost of a potential profit.
Let’s suppose that you have $ 1000 on your trading account. You can spend this amount, let’s say, on 10 shares. But if you use a leverage equal to 1:10, your deposit will grow to $ 10 000. And you may afford to buy ten times as much. If in this case the share value increases by 10 dollars, your profit will make 10 % of your deposit. It means that when you apply borrowed funds, you may get $ 1 000 of a net profit returning your initial deposit. If you trade with your own funds only, the profit will be only $ 100.
Now let’s consider another situation. You buy shares being funded by a broker. Their value decreases by the same 10 dollars we have assumed in the example above. In this case, if you trade only with your own funds, you’ll lose $ 100. And if you use leverage, your loss will be $ 1 000. In addition, you should remember that an amount of $ 9 000 you have in pocket is not yours and you are expected to return it to a broker. Thus, you lose all your deposit.
Leverage volume and requirements
By contrast with a bank loan, margin lending is much more available. You can get it easily without providing any documents or concluding any additional agreements. Usually, an agreement for brokerage service includes a provision describing this option. But there are some conditions, which should be fulfilled if you want to benefit from the opportunity provided by margin trading. First, in order to take a leverage position, you should prove that you are able to cover a loss if it occurs. The broker wants to get assurance that he will return his money if your trade fails. As a rule, a particular amount on your deposit is used as cover funds – a margin which will be taken as pledge of collateral. The margin value depends on a proportion of percent of the half a transaction value. It depends on the terms of a particular broker and types of assets bought on credit. In addition to a cash cover, the assets owned by a trader can be taken as a pledge of collateral too. But, what is meant here is liquid securities only, which can be sold immediately to cover losses. In some cases, the assets, which a trader is trading with, are taken as a pledge of collateral.
The maximum level of leverage is specified by every broker in his trading terms. Some brokers provide a leverage equal to 1:1000, increasing a trader’s deposit thousand fold.
|Asset Capital Business inc (ACB)||1:1000|
Comparison table of terms from leading brokers
Leverage trading risks and ways to reduce them
Leverage is an instrument increasing a potential profit and risks alongside with that. As we have mentioned before, leverage trading can result in a loss of an entire deposit. Broker, providing a credit, arranges a credit repayment beforehand. He uses a Stop out option. This is a forced closing of trader’s adverse positions. As a rule, Stop out is applied when a level of a loss ratio is equal to 85% – 90% of the pledge. Before the positions are closed, a trader is informed that he has to deposit more. This option is known as Margin Call. The standard package plan of broker services includes it. The level of Margin Call is established by every broker on an individual basis, but mostly an alert message comes when the deposit is less than 30% – 20% of pledge amount. Receiving such a message, a trader should either deposit an account, or close adverse positions by himself. Otherwise, this will be made automatically without further notice, by applying a Stop out option, if the market situation does not change.
Another option for reducing risks is Stop loss. This is an automated close of all positions that occurs when a specified threshold is reached and when a price for assets starts changing against the trader’s goals. It allows closing the positions before they yield losses. Stop loss is set by a trader and its value depends on his trading strategy and risk appetite. Stop loss can be set automatically by a trading terminal, or a buy or sale order at a fixed price can be given to a broker. The opposite of Stop loss is Take Profit. This option allows closing a trade at the most favorable rate for a trader.
Pros and cons of margin trading
The key advantage of margin lending is the possibility to trade when there is a lack of funds on a trader’s deposit account. Leverage allows increasing the deposit even thousandfold. This option offers more opportunities for profitable trading. Well, a trader is expected to have a thousand dollars at the minimum on his deposit account in order to get involved in Forex. Not all traders can afford such a sum that is why margin lending is a perfect way to enter the larger financial markets. Also, using leverage, a trader can increase his initial deposit within a very short time if he is lucky to close profitable trades. As opposed to regular credit financing, a trader does not have to pay any credit interest to a broker when he uses leverage. He is expected to return as much money as he has borrowed. And brokers do not get any part of a trader’s gain from trades.
Speaking about disadvantages, we should say that a key risk you should consider using leverage is a loss of your deposit. If leverage trading is failing, the loss is far in excess of losses a trader may suffer when he is trading with his own funds only. That is why margin trading is not recommended to beginners and hot-headed traders as any mistake in a trading strategy costs too much.
Margin lending is a rather convenient financial tool, which allows a trader to gain a lot having a relatively small amount of his own funds. But it is important to remember that the coin has a reverse side. Leverage increases a potential profit but also it raises a loss risk – a trader can lose all his money on a deposit account. That is why if you are not completely sure in your trading strategy, you’d better avoid trading with a leverage of a large value. Otherwise, even slight fluctuations in exchange rates can result in losing.