What is margin trading: advantages, disadvantages, risks

It is possible to earn much more than usual on the stock exchange if you use borrowed funds. Or you can lose all your money and still owe money to your broker. Here’s what an investor needs to know about margin trading.

What is margin trading

What is margin, and what is it?

When an investor wants to spend more money on a trade than he has, he can borrow money from a broker. Then the collateral will be his own funds on the brokerage account – they are blocked as a kind of security deposit. This amount is called margin. Margin is recalculated every time a trader opens a position.




Two types of margin are calculated: initial and minimum.

Initial margin – initial security for a new transaction. It is calculated by multiplying the value of the asset by the risk rate.

The risk rate is the probability of change in the price of the asset at the exchange. As a rule, the higher the volatility of an instrument, the higher the risk rate. Brokers usually publish their risk rates for assets on their official websites. Please note that the risk rates for short trades are always higher than for long trades.

The minimum margin is the minimum collateral to support the position you have already opened. Usually, the minimum margin for one liquid asset is equal to half of the initial margin.

To calculate Initial and Minimum Margin for the entire portfolio, add up the Initial and Minimum Margin for each liquid asset. If the value of the liquid portfolio falls below the initial margin, you will be able to buy back some assets in the uncovered position, but you will not be able to enter into new trades.

Important! When calculating the initial and minimum margin for the entire portfolio, the ruble on the brokerage account is NOT taken into account.

The liquid portfolio is the aggregate value of the currency and liquid securities in your brokerage account. Shares of foreign companies, currencies, and Euro bonds are accounted in rubles at the current exchange rate.

However, if the value of the liquid portfolio falls below the minimum margin, the broker will have the right to forcibly close some of your positions, so that the value of the liquid portfolio does not fall to zero and go into deficit. The broker is entitled to choose the positions that he considers necessary to close.

Before you close your trades, the broker will send a notification that you need to fund your account for the required amount. This message is called a margin call.

What is long position trading?

A long position is trade-in anticipation of an increase in prices. The idea of a long position is to buy a stock when it is cheap and sell it when it is up. Traders can enter long positions not only with their own funds but also with borrowed funds, i.e. funds provided by the broker.

In that case, potential profit increases, but losses from unsuccessful deals are on the investors’ shoulders as well. For example, you bought ten shares of Tesla at $700. A few days later you sold all the securities for $800 per share. Then your profit would be $1,000.

If you used margin trading and your broker gave you the opportunity to buy twice as many shares, your purchase amount would be $14,000 and your profit would be $2,000. As you can see, when using borrowed funds, your investor’s profit would be twice as much. But, of course, you have to take into account transaction fees and rollovers over several days.

Now consider a negative scenario: Tesla stock has fallen to $600. Your loss would be $1,000 if you used only your own money. But if you had bought it with x2 leverage, your loss would have been $2,000.

As you can see from this example, margin trading increases not only potential profitability, but also losses. Before using leveraged trading, one must learn to control risks, not be afraid to fix small losses, and use take-profit and stop-loss.

How does a margin long trade work?

Let’s say we have ten Tesla shares in our brokerage account with a market value of $700. There is $1,000 in the account, and we want to buy some more Apple securities.

The broker will first calculate the size of our liquid portfolio. It will be: $700*10 stocks + $1k = $8k.

Next, the broker will calculate the initial and minimum margins.

The initial margin in our example will be calculated the following way: $700*10 shares*50% (assuming that it is the long position risk rate on Tesla shares) + $1000*10% (assuming that it is the long position risk rate on the dollar) = $3.6 thousand.

The minimum margin is equal to half of the initial margin, i.e. $1.8 thousand.

Next, when we want to buy Apple stock, the broker will calculate the maximum transaction amount. It is calculated as follows: (liquid portfolio – initial margin) / long risk rate on the asset (in our case, Apple)

In our example, the transaction limit will be equal to ($8 thou – $3.6 thou) / 25% (assuming that it is the long risk rate on Apple shares) = $17.6 thou.

Let’s assume that the market price of Apple stock is now $100. So at most, we can buy 176 shares of Apple stock. But let’s say we decide to buy only 100 shares. Then this is what our portfolio will look like:

– 10 shares of Tesla, with a total value of $7,000;

– 100 shares of Apple, worth a total of $10,000;

– “minus” $9k (we had $1k and bought $10k worth of Apple stock in debt).

The broker will then recalculate the value of our liquid portfolio and its initial and minimum margins. This happens every time the composition of the liquid portfolio or the price of the assets in it changes.

As written above, if the value of the liquid portfolio is higher than the initial margin, we will be able to make new trades. If it is lower than the initial margin but higher than the minimum margin, we will be able to buy back some assets but not make new trades. If the value of the liquid portfolio falls below the minimum margin, then the broker will be entitled to forcibly close some of our assets.

margin trading

 

How does short trading work?

You can make money not only on the rise in the value of stocks but also on their fall. Let’s imagine the situation: Microsoft shares are trading at $200, but we think the price is overvalued and the securities are about to fall, but we do not have these shares in our portfolio.

Then we borrow the shares from a broker against cash, and he sells them on the market. Then we wait for the stock to fall to $180, for example, and we buy it. When we buy the stock, we automatically return the stock to the broker (remembering that we borrowed it), and the difference between the sale and purchase will be our profit, in this case, $20.

How it happens technically: when we sell shares that we don’t have, we get a line “minus one Microsoft share” in the portfolio. The account also receives funds from the sale – $200.

All calculations regarding the minimum and initial margin and the liquid portfolio are similar to trading long, but the risk rate is taken as “short”.

For each day of use of the broker’s assets we pay a certain sum of money, the conditions of margin trading should be checked with the broker. However, this also applies to trading long, so it is better to use margin trading for short-term transactions.

Trading short is much riskier than trading long. When we play short, the mathematical expectation plays against us: the stock may fall to 0 at most, i.e. minus 100%. But stocks may grow indefinitely, i.e. 100%, 200% or even 500%. When trading on the short side, the investor takes a knowingly risky position, therefore it is even more important to evaluate the risks in advance, define the maximum possible losses in the transaction and set a stop loss.

Pluses and minuses of margin trading

Advantages:

  • the larger size of potential profit due to opening positions using borrowed funds;
  • It is possible to trade not only upwards, but also downwards by entering into short positions.

Cons:

  • Increases the amount of loss on an unsuccessful trade;
  • not all the instruments can be shorted by the broker;
  • it is necessary to pay a commission for the transfer of an uncovered position (even on nonworking days);
  • if the value of the liquid portfolio falls below the minimum margin, the broker may forcibly close the positions.




Kevin Doran

I have been trading forex since 2015. Over the past few years, I have tried and tested all the most popular Forex Brokers. I publish my reviews to help you choose a reliable broker and reduce your risks.

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