Margin trading is investing with borrowed money. It allows you to buy more financial products such as stocks, options, or futures, than with your available budget. Using borrowed money is also referred to as “leverage” because leverage is applied. The results are multiplied and you have the opportunity to increase your yield. But this leverage exposes you to considerable risk of loss. When you practice margin trading, your existing portfolio serves as a security deposit. If prices go down, your broker may make a margin call. This article explains the basics and the different elements of margin trading.
The following topics are discussed:
- How does margin trading work?
- What are the advantages of margin trading?
- What are the risks of trading on margin?
- How to limit the risks associated with margin trading?
- Summary and glossary
How does margin trading work?
Let’s take an example to explain margin trading:
Imagine that you have € 10,000 in your account and you buy € 15,000 in shares. You, therefore, need to borrow € 5,000 from your broker to buy these shares. So you buy 5,000 € on margin and pay interest for the
Imagine that you have € 10,000 in your account and you buy € 15,000 in shares. You, therefore, need to borrow € 5,000 from your broker to buy these shares. So you buy € 5,000 on margin and pay interest on the amount you borrow. Buying on margin is only possible if you have a margin account. This is because buying stocks with borrowed money is not possible with a cash account.
What are the advantages of margin trading?
The advantage of margin trading is that it allows investors to take larger positions. If the investor’s forecast should be correct, then the price is moving in the right direction. Its gains are higher thanks to the leverage that is applied. Some financial products, such as currencies, are generally not very volatile. Using the margin allows for high returns. The other side of the coin is that the risk of loss is amplified by leverage.
The risks of margin trading
Marginal trading involves different risks.
First of all, using leverage amplifies the results. When the trade fails, the investor suffers greater losses.
In the event of a margin call, it is possible to lose more than the initial bet. During a margin call, the investor must pay an additional amount or close part of his portfolio. Because in this case, the leverage has become too important compared to its capital. Cash accounts do not work with leverage. The maximum loss is therefore limited to the stake.
As loans, the margin is not free. On the one hand, interest rates weigh on yield. On the other hand, these can be flexible. Therefore, costs can fluctuate. Using margin can make the portfolio more volatile. Therefore, it is recommended to carefully monitor the margin in your portfolio, if you use it.
How to limit the risks associated with margin trading?
The risks associated with margin trading are numerous, which is why it is important to limit them. The first and easiest is to limit the margin. If the leverage is low then the losses do not directly generate a margin call. Financial products are volatile and too much leverage can lead to catastrophic results. Another method is to limit the risks of the margin by using a diversified portfolio. The advantage of a diversified portfolio is that while some products are going up, others are going down. The probability of registering large losses is, therefore, smaller and the use of leverage is more secure.
Good preparation can be useful to limit the risks. Many investors panic when they have losses, losses that continue to pile up. By making a plan, you know what to do in the event of sudden price fluctuations. Being willing to take losses is part of this plan. Many investors do not readily accept to take their losses, as it is well known that no one likes to admit their mistakes.
Summary and glossary of margin trading
Margin trading allows investors to take higher positions than if they were doing so with their own money. The results are therefore multiplied through the leverage effect. Amplified Results, therefore, translate into higher gains and greater losses. Therefore, it is important to limit the risks, be aware of them, and have a plan to manage them.
The 7 rules of margin trading to remember
- The margin trading refers to using money borrowed from a broker to finance a transaction. Financial products are purchased serving as a security deposit.
- The margin is the amount that you can borrow against your margin account. The amount is determined by the broker’s requirement and the amount of clean money available in the account.
- Margin debt is a debt that you have saved on your margin account.
- A margin call is when the amount of equity drops below the minimum level set by the broker. At this point, the investor must sell part of the portfolio or pay an additional amount. The minimum quantity is referred to as the maintenance margin and is set between 30% and 40% with most brokers.
- The overnight margin is the margin required to hold a position from one session to the next, overnight, when the stock markets are closed. Holding financial products outside of trading hours means that you cannot sell them directly. This explains why the overnight margin is higher than the maintenance margin one needs to have to trade on the same day.
- A minimum margin is a minimum amount available in the margin account to be able to trade on margin. This threshold is set at (an equivalent of) $ 2,000 because margin trading is reserved for serious investors.
- The initial margin corresponds to the own capital to be deposited during the initial purchase. The amount of this own capital differs depending on the financial instrument. For stocks, it’s usually 50% of the purchase price. For less volatile products like currencies, this percentage may be lower.