Leverage and margin

Borrowed power

Leverage means controlling something big with a small amount of your own money.

Think about buying a $300,000 house. Many people pay $30,000 themselves and borrow the rest from a bank.

• The house goes up 10%, to $330,000. They made $30,000. That's 100% of the money they put in.
• The house goes down 10%, to $270,000. They lost $30,000. That's all of the money they put in.

Same 10% move. A huge win or a total wipeout. That's leverage. It makes wins and losses bigger by the same amount.

Leverage in trading

Say you have $1,000, and your broker lets you control $10,000 worth of something. That's 10 to 1 leverage.

• Price goes up 5%: the $10,000 becomes $10,500. You made $500. That's half your money, as profit.
• Price goes down 5%: you lost $500. Half your money is gone.
• Price goes down 10%: you lost $1,000. Everything.

Futures have leverage built in

One futures contract controls a lot. Pretend the Nasdaq 100 is at 20,000 points.

• One NQ contract is worth 20,000 x $20 = $400,000.
• One MNQ (micro) contract is worth 20,000 x $2 = $40,000.

You don't need $400,000 to trade one NQ. You only need to keep a deposit in your account, called margin.

What margin is

Margin is not a fee, and it's not the price of the contract. It's a good-faith deposit your broker holds while your trade is open, to cover losses. Think of the deposit when you rent bikes: you get it back if nothing goes wrong.

• Initial margin is the deposit you need to open the trade.
• Maintenance margin is the smallest amount you must keep while the trade is open.

If losses push your account below that level, you get a margin call. Your broker asks for more money. If you don't add it fast, they can close your trade for you, at a loss.

How much margin is needed? It's different at every broker, and it changes. Brokers and exchanges can raise it overnight when markets get wild. Always check your own broker's current numbers, not a number you read somewhere.

Stocks can use leverage too. In a "margin account," the broker lends you money to buy more shares, and you pay interest on that loan.

The big mistake

Low margin makes people think, "My small account can trade 10 contracts!" Being allowed to doesn't mean you should.

The amount you risk should still come from the position size recipe: about 1% of your account, based on your stop. Leverage only tells you the most you could trade. Position sizing tells you how much you should.

Remember

• Leverage lets a small amount of money control something big.
• It makes wins and losses bigger by the same amount.
• Margin is a deposit, not a fee. The amount differs by broker and can change.
• Let position sizing, not leverage, decide how big you trade.