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What is Leverage?

Investors attempt to profit from changes in the price of financial assets through trading. Since changes in the price of financial assets are pretty small, you wouldn’t generate much profit if you trade only with your own funds. For this reason, traders use financial leverage to generate greater buying power in the financial markets.

Overview: What is Leverage?

Leverage is a financial credit that you take from your broker to trade larger amounts of money. With greater buying power, you subject yourself to larger profits but at the same time, you also expose yourself to a large amount of risk. The more you can profit with leverage, the more you can lose if the market turns against you.

Day trading, for example, occurs via leverage. Since day traders open and close their trades intraday, they aim for small price moves.

How Leverage Works

If you want to start trading forex or other financial assets, your broker will have specific leverage rules you’ll need to follow. Leverage should always conform to the domestic law which regulates the respective trading broker.

Imagine you have $10,000 in a stock trading account and your broker lets you trade 4:1. In this case, 4:1 means that you can trade four times more money than what you have in your account. In this case, you have a buying power of $40,000.

You back up the leverage that you use from your broker with financial assets or money. In other words, your broker will never lend you money if you don’t have a certain amount of equity in your trading account, called margin. Margin is similar to collateral for your broker in order to let you trade with leverage.

Brokers can have different margin requirements, so get familiar with the margin requirements of the broker that you want to use before you start trading on leverage.

Different brokers can offer you different leverage conditions. Also, different financial assets will be subject to different rules. The different financial assets can come with different leverage and can have different margin requirement. Forex, stocks, commodity, ETFs, indices, cryptocurrency – these tradable assets can be subject to different margin requirements and leverage.

Risk Management

If the price of an asset goes below a specific level, you might get a margin call. The margin call is the worst thing that can happen to a trader or an investor.

Your broker will ask you to deposit additional funds to cover the price difference. If you don’t do this in a timely manner, your broker will liquidate your trades and your account will suffer the whole loss.

You should follow all risk management rules to cover your broker’s margin rules to avoid a margin call. Here are some of the common risk management instruments and techniques:

1. Have a Diversified Portfolio

If you invest in more than one trading asset, you will have other assets to cover you in case one of them fails. You can consider an index, which contains many stocks – like the S&P 500. This way, if some of the stocks perform poorly, the others will buoy you.

Bear in mind that there have been general stock market crashes throughout the years. This means that this technique does not guarantee your funds, but nothing is 100% safe or sure when investing or trading. The goal is to maximize your profit and minimize risk.

2. Use a Stop-Loss Order

The stop-loss is an automatic market order which closes your trade at a specific level chosen by you. You can always use a stop-loss order for your trades. This way, you limit the loss in case the price runs against you.

You can use the stop-loss to choose exactly how much you want to risk for each of your trades. It’s not recommended that you risk more than 1-2% of your account per trade, which guarantees you a minimum of 50-100 trades with your trading account. If you lose them all, you’ll go bankrupt, but what are the odds of 50-100 losing trades in a row?

Never forget to take leverage into consideration when calculating your risk. Here is how to do this in four simple steps:

  1. If you maintain an account of $50,000 and you trade with a leverage of 4:1, then you have a buying power of $200,000.
  2. If you invest 50% of your buying power in each trade you get $100,000.
  3. If you want to limit your loss to 1% per trade: 0.01 x $50,000 = $500
  4. Your stop-loss needs to be at a distance equal to $500 / $100,000 = 0.005 or 0.5%

Apply the specific margin rules to this formula in order to get the results. Fortunately, most automated trading platforms will do these calculations for you.

Which Brokerages Offer Margin Accounts

Three of the best online brokers are Ally Invest, E-Trade, and TD Ameritrade, each is very competitive and offers some of the best margin trading conditions.

1. Ally Invest

Best For
  • Active traders
  • Beginners looking to start trading
  • Low fees

Ally Invest is a regulated broker which offers margin account to its clients. It is among the top 25 U.S. financial holding companies that offer financial products. Ally is listed on the New York Stock Exchange under the symbol ALLY.

Requirements

  • Minimum amount required to trade on margin: $2,000
  • Maximum margin: 50%
  • If you want to buy certain securities via a margin account, Ally Invest will finance 50% of the deal, or leverage of 2:1. Notice that this percentage can vary depending on the security you want to buy.

Rates

Ally Invest remains competitive in terms of rates on its margin account. The bigger your margin balance, the less you pay on rates. The margin rates vary from 5.5% to 10% based on the size of the margin balance.

Read Benzinga’s full Ally Invest Review

2. E-Trade

Best For
  • Mobile traders
  • Traders looking for research and data
  • Investors looking for retirement planning guidance

E-Trade is another highly regulated U.S. broker. E-Trade is publicly traded and is listed on Nasdaq under the symbol ETFC.

Requirements

  • Minimum amount required to trade on margin: $2,000
  • Maximum margin: 50%

Rates

The margin rates at E-Trade are also lower for larger margin balances but are slightly higher than the ones offered at Ally. E-Trade’s rates vary from 7.5% to 11%, based on the size of the margin balance.

Read Benzinga’s full E-Trade Review

3. TD Ameritrade

Best For
  • Beginner investors
  • Advanced traders
  • Investors who want portfolio-building advice.

TD Ameritrade is also a U.S. based broker, subject to the highest finance regulations. It is known as one of the best online brokerages in the U.S. and even in the world. TD Ameritrade is publicly traded on Nasdaq and holds the symbol AMTD.

Requirements

  • Minimum amount required to trade on margin: $2,000
  • Maximum margin: 50%
  • A minimum of its total value as equity at all times: 30%

Rates

Margin rates at TD Ameritrade are also progressive. The bigger the margin balance, the lower the rate. They are higher than Ally Invest’s as well. TD Ameritrade maintains margin rates from 8% to 10.75%, based on the margin balance.

Read Benzinga’s full TD Ameritrade Review

Final Thoughts

Trading on leverage in a margin account contains a big dose of risk. If you haven’t properly calculated your money management strategy, you can easily wipe out your account and go bankrupt.

One of the most important trading rules is that you should never trade with money you cannot afford to lose. It’s not a good idea to put your savings or your child’s college fund on the line. Be prepared for the consequences it can have on your long-term finances.

Compare Online Brokers
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$6.95 for fewer than 30 trades/quarter. $0 Learn More

Flat-fee pricing: $5 per trade, Per-share pricing: $0.006-$0.01 per share ($1 minimum per trade) based on trading volume, Unbundled pricing: $0.002-$0.01 per share ($0.50-$1 minimum) based on trading volume $5,000 for individual retirement accounts (IRAs) Learn More

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Free $0 Learn More

$0.005 per share minimum $1 and maximum 0.5% of trade value; volume discount available $0 for cash account, or a margin account with $2,000 Learn More