Leverage, Margin, Balance, Equity – understanding how your trading account works

Leverage, Margin, Balance, Equity – understanding how your trading account works

Learn the difference between terms and understand what a trading account consists of

We know that trading and the financial markets, and everything related can be a difficult subject– like the one you hated in high school, but later, you realized that it is actually useful. You've probably heard your friends talking in terms that you don't understand, or you don't know precisely what they mean. You don't have to be an academic to know some of the most used terms when it comes to trading – we wrote this article to help you understand more.Now that we set the ground, let's discuss it a little bit in-depth, and we'll start with, let's say, the easiest one:

Balance

Putting the dictionary to work, we will discover that balance is the “amount available in an account for withdrawal or use. Computed by summing up all cleared or credit deposits, and deducting all withdrawals, debits, and service charges.”

In trading it goes two ways:

  1. The value of the account without the profit/losses from open positions;
  2. The account's value consists of the money that you deposited and the profit/loss from closed positions.


Equity

When we refer to a company and talk about equity, we usually mean the amount of money that an investor could get if that company's assets would be liquidated and the debt paid off. It is also known as shareholder equity or owners’ equity, and it represents the shareholder's/owner's stake in the company.

But when it comes to trading, things are a little different. Unlike balance, which represents the account’s value without the profit/loss from open positions,equity includes the balance. It is the value the account has – balance plus profit/losses from open trades.

However, when there are no open positions, therefore no profit/losses, the account's equity, and balance are the same. To give you some perspective, let take an example which includes the two terms:

If you have a position that’s on $500 profit and you close it, and the account balance is $4000, the account's equity is $4,500.

It is easy to see how a novice could get the two of them, balance and equity, mixed up. Don’t worry, if you are a novice in this field and would like to know more about financial terms, please check our Financial Dictionary and the Featured Articles section on CAPEX.com!


Leverage

Putting the dictionary to work once again, we will find out that leverage is a term used to express "the relationship between the amount of money that a company owes to banks and the value of the company," also, "the act of using borrowed money to buy an investment or a company."

Let me give you a straightforward example from the same dictionary: “With leverage, the investor’s $100,000 buys $500,000 or more of stock if he wants.” Or, commonly said: an investment technique in which a small amount of money is amplified for making a more valuable investment (it allows traders to work with more significant amounts although the account balance is lower).

Leverage can be used by companies, and also by investors. Companies are usually using it to finance their assets. If a company chooses not to issue stocks to raise capital, it can use debt to invest in business operations and try to increase its shares. While companies use debt, investors can use options, futures, and margin accounts. Leverage results when one uses borrowed capital to fund the investment meant to expand its asset base and obtain returns on risk capital, or the amount of debt used to capitalize on assets. The endpoint is a multiplication of the potential gains from an investment. Simultaneously, the leverage also multiplies the potential risk that could arise if the investment goes south.

Although it sounds fantastic in theory, leverage is more than meets the eye – it's a sophisticated tool, which, as said before, magnifies both gains and losses – where the loss is much more significant than if the investment was without leverage.

It doesn't matter if you are a beginner in this business or not; leverage trading must be done carefully, taking into account that although it multiplies the gains, it does so with the risks as well.


Margin

Although the margin is in the same area as leverage as it involves borrowing, it is not the same. While leverage is all about taking debt, margin refers to the deficit or borrowed money used to invest in financial instruments.

Plainly said, it is the difference between the overall value of the investment and the loan, where the loan is the amount of money borrowed from a broker.

There are various terms and expressions in the finance sector and the trading world related to margin. Let us bring some light to it:

  • Buying on margin: the most straightforward thing one can do – borrow money from a broker to buy stock, but to do that, one must need a margin account. The margin account could be part of the standard account, or it could be a different one.
  • Maintenance margin: represents the minimum balance one has to have before the broker requires more funds to pay the loan.
  • Margin call: when the account is in danger due to lack of available margin.
  • Accounting margin: is used in business accounting, and it's the difference between income and costs.
  • Margin in mortgage lending: when banks need to determine the new rate on mortgages, it adds to a determined Treasury index a margin. For example: 6% (index rate) + 4% (margin) = 10% (mortgage rate).

For traders, experts like James Chen, Amy Drury, or Alexandra Twin, who have worked for companies listed on NYSE, CNN, and Deloitte, with more than 15 years of experience, recommend making short-term investments when buying on the margin.

Do you think you understand leverage, margin, balance, and equity? Perfect! Then you can take a look at other financial terms by accessing our Financial Dictionary, or you can participate in webinars organized by an analyst who has over 30 years of experience in the financial market. Missed a webinar? Don’t worry, have a look at our educational videos that you can find on the Trading Academy section!

Sources: businessdictionaty.com, investopedia.com, dictionary.cambridge.org


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