margin trading

What is Margin Trading

In the simple words, margin trading is just trading using loans from the broker. In margin trading traders leveraged to access more funds for trading purpose. It has ability to potentiate the gains when used with due care. Greater returns on the successful gains is the prime advantage of margin trading.

The Margin trading is widely used in low volatile market (Stocks and commodity) as well as in the highly volatile market (Forex). Now day cryptocurrency is also included in this list where margin traders borrow currency from other traders against the interest payment.

Here, margin is the sum of money which needed to open a leveraged position. It is different between your position/funds and funds lent by the broker. I always describe it as the deposit that we require using the leveraged product, and this is the short introduction of margin.

It is here form decades for the good reason that is “to provide flexibility to traders to use the strategy to get advantage of opportunities”. Without margin every investor may not be able to trade in the market.

How to Get Margin Trading Capabilities

Nowadays it is not easier to get margin trading capability specially for stocks trading. While in other markets every broker is offering leveraged traidng account. Broker make money from both side, from the transaction as well as in shape of interest on the loans/margin. The margin trading account agreement is always a different one from cash trading account.

Breaking Down The Name “Margin Trading”

Margin is the money that one borrows form the broker. The term that we use mostly “buying on margin” refers to the same means borrowing money from broker. In margin trading practically investor pays a percentage of the total amount of security and borrowed rest from broker. Technically seeing margin is a difference between the service’s selling point and production cost.

What does it mean?

This is common practice where investor use borrowed funds to the financial assets. The purchased security/Asset serve as a collateral for the borrowed money/loan amount. A margin trading account is always different from the standard cash trading account because it has specific restrictions in it.  Short sales are only possible in the margin trading account.

What is Margin Trading

Certain types of instruments, like commodities, futures and currencies, are only trade able in margin trading accounts. Stock brokers use simple rule of margin trading for more volatile stock/securities margin requirement is high. For low volatile securities margin required is less.

Leverage is a By-Product of Margin

Leverage enables traders to enter large positions what they could not with their personal capital. For a trader who do not understand it there it can be a dangerous tool, as it can amplify the losses. The relationship of margin and leverage is best described in the picture.

Margin Trading

If your broker have margin requirement of, 

  • 5%, then your leverage will be 20:1
  • 3%, then your leverage will be 33:1
  • 2%, then your leverage will be 50:1
  • 1%, then your leverage will be 100:1

Benefits of Margin Trading

By selecting the margin trading you are going to access a wide variety of potential advantages of this trading method. Few of them are as under,

Leveraging Your Gains

Margin Trading

“Opening Several Positions with Relatively Small Amounts”.  Purchasing securities with the margin trading enable trader to leverage the gains by enabling you to buy more securities.

Margin trading is a popular trading method it makes possible to trade more with the small amount of investment and more positions means more profit.

Avail Multiple Trading Opportunities

While trading with the margin you can avail the opportunities that come into your way.

Because bigger margin can give you ability to take more positions. You can take advantage of any existing trading opportunity without adding cash.

Diversification Becomes Easy in Margin Trading

A margin trading account is very effective in diversification and hedging the portfolio.

You will improve general diversification while investing in different sectors.

With the Margin trading account diversification become easy as due to large available margin trader diversify his portfolio. While taking positions on multiple securities in different sectors.

Carry Trades and Margin Trading

For me carry trade means borrowing at low rate of interest and carrying a position which is promising one.

A position which have ability and can produce higher returns can be carried.

Lower Initial Cash Investment.

With the margin trading account you can take a start with low investment and this also provide opportunity to diversify your investments.

As other investment can be used somewhere else for stable returns.

Increased Cash Dividends

Margin trading not only enhances your trading power but also brings a very positive benefit with it. When you are holding the large amount of securities that will result into increased dividends. I know many traders who use dividends to manage the interest cost.

Risks Associated with Margin Trading Account

Just as there are an array of advantages, so too are there a variety of risks. The ones we’ll go over are magnified losses, the margin call which become very expected for novices, liquidation by force when you remain fail to met with the margin requirements, interest charges and rate risks which may increase, and monitoring accounts/portfolios.

As there are array of advantages to trade with the margin trading account, there are variety of risks too.

Margin utilization break even

If we have a look on the marketing material of margin trading account that look too fascinating. In actual an investor needs to do his due diligence on margin account.

Upside of margin account is promising but it may invite some unfavorable circumstance with it like,

Maintaining a margin trading account is risky but not for all the investors.

I always write that leverage is a double-edged sword it can amplify the losses and gains to the same degree.

Loss of Capital

Due to use of margin trader always buy more securities and if trades went against him than his account may dried up. Suffering with the margin call always bring a lot of challenges with it.

Coverage Demands for Possible Losses

In the weakening market margin trading accounts are in a risky place. Brokerage firms demands to add more funds to cover potential losses and force to do it in very short time.

Forced Liquidation in Margin Trading

While running a margin trading account investor may have to sell the securities just to covers the losses incurred in his account. Running losses pushes him to liquidate the contract which can return profits in the future.

Even the worst thing can happen where broker may sell the security without any say in matter.

Like when you account dropped below from necessary required margin some of your positions will be closed by your broker automatically. Broker execute his authority in the light of the margin loan agreement.

Which states that a broker has the legitimate power to close the positions if investor fails to inject funds in case margin is dropped from the required level.

Additional Margin Requirement

One more bad news is broker can increase the margin requirement at any time like on festival holidays or when a highly volatile event is ahead.

Which can bring some new challenges for investor.

Your margin positions are monitored 24/5 and if at any given point a certain threshold reached than a margin call may arise.

Where more margin will be required to maintain the positions and broker will immediately call for additional margin to meet the difference.

Margin Can Magnify Losses: Like I already mention earlier Upside of margin trading account is promising if can multiply the profits than on the other hand it also can multiply the losses. before applying for the margin trading account consider both sides.

Losses can exceed from initial investment: As an investor or speculator when you are on the flip side and experience poor liquidity there your losses can exceed from your initial investments. Which is the worst drawback of margin trading specially when you are trading derivatives and stocks.

Interest charges: In the margin trading account interest cost on the margin debts adds up over the period of utilization until you hold the security.

Which may erode the gains made by same security/trade. Interest rates fluctuate over the period of time and may add additional burden on the margin trading account holder/investor.

Effect of Price Bands  and Margin Trading

In the exchanges the majority of margin enable trading securities have upper and lower price band.

And when the price fall to that band level like -20% there your account should have enough balance to accommodate that losses other wise some part of your positions will be off-loaded.

Consider this resource for better understanding of effect of price bands

Limit period to Close out Leveraged Positions

In the stocks trading it necessary to close all of margin positions before the end of settlement. I believe that this is the most tough restriction for trader.

As when a position is running with the trend, investor do now want to close that. you shall have to close your positions even if that involves a large loss. In such situation you may lose the chance to recover your losses if market recoup in the result of the settlement.

If you do not close your positions on the last day of settlement, the broker will close out the positions. 

Broker cannot guarantee the closing of positions its your responsibility and if remain open then onus is on you, to arrange further funds to settle the positions.

Extra Vigilance: Margin trading account needs to be monitored all the time with the open eyes as a single wrong trade and certain wrong decision can lead towards disaster.

Especially when the investments are made on the multiple assets and all the available margin is utilized to get maximum gain. Monitoring on the constant basis is inconvenient for trader.

Techniques for risk mitigation

To get maximum benefit from your margin trading account and to use the leverage in best way consider following advice,

Margin Trading

Invest Wisely

The single rule which also called rule of thumb here is that one should not invest the money into margin trading account that he cannot afford to lose.

Here the trader/invest needs to understand that the any losses in margin trading will be increased by many times.

As a trader only invest if you can afford to lose the money and have sufficient funds to experience any temporary move against you.

Borrow Less Than The Allowed Limit

Plenty of funds are available that doesn’t mean investor should squander it by investing in all available securities.

An individual trader needs to invest small amount at first and with the count of time when his confidence builds up and his skills too there, he may increase the investment.

Borrow in Short Term

At the end the additional amount available to trade in our margin trading account is a loan and you have to pay interest on that.

If you invest that amount in long term trades/positions where you expect less return. As interest of margin on these positions will eat up your profits.

Do not Merry with Trades

If you are trading a margin trading account, then always prefer to cut your non-performing trades as such trades only increase your cost of doing business.

When you cut these trades, the same margin will become available to use in next opportunities which might bring better returns for you.

Use Margin for a Diverse Portfolio

While handling a margin trading account you need to invest in the collection of securities to reduce the chances of getting margin call.

Or you may trade diverse exchange traded funds to reduce your risk of margin call.

You will become susceptible to a margin call when you take large exposure on single security. Unexpected always remain expected as company may miss the earning target and or any other internal or external regulations may hit the badly.

The same will be reflected in the market.

If you have a large position in a stock, you arr susceptible to a margin call. This is because any number of events can result in a decline in the stocks price.

Where earnings remain less than expectations, a development in the company’s internal affairs, regulatory alterations by government, a drop in the market share, and many others.

Prepare to Take Losses

Losses are very possible and part of this business. Get into the mindset of a trader and accept losses as an inevitable outcome of trading.

This simply means exit from your trading position even with the small loss. Your success will depend on your decisions to cut the losses.

This is in wait of hoping that the stock in inventory will turn around to the same position from where you catch it/entered into positions. At the same time watching your losses which become out of control gradually.

Risk Management Technique

This is another risk mitigation technique used in trading named as a risk management. It helps a trader to cut down the losses and protect is equity in his account from losing all money in just one bunch of trades.

Nowadays in highly volatile market it is a crucial prerequisite, one that many traders overlook to profitable trading.

How to handle risk in margin trading

Without proper risk management while handling the margin trading account you can lose of the profit from the multiple winning positions in just one trade.

When you choose to trade with the margin trading account there it is a good idea to develop a risk management plan for your trading investment.

It is not a hard to do thing as basic idea is to monitor the investments and being up to date on all related market activities. When you lay a proper risk management plan it will tell you that where to look for the potential risk.

While using the stress test you can formulate your strategy in advance.

To manage your risk, it is also good to have a margin trading account with the same broker where you are running your cash trading accounts and other investments.

It will help you to add additional funds in the margin account within no-time.

Management Techniques for Margin Trading Account

These are some potential strategies which can help you to protect your profits and trading capital as well.

Plan Your Trades

This is the most advised management technique in trading that, at first plan your trade and then trad your plan. You cannot remain in the market all the time so make it sure that your broker allow frequent trading as many brokers charge higher commission for it.

manage your risk

And also make it sure right analytical tools are offered by broker to make analysis.

Do not make decision on the basis of hope that your trade will earn money for you. I see that losses always provoke traders to hold trades in the hope that it will return and become profitable.

A planned trade can bring best results and always a tension less trade.

Use of Percentage Rule in Margin Trading

Decide principally that how much percentage of your capital your will risk in a single trade and in a single session or in a single day. Like most of day trader prefer to follow the rule of two percent while long term traders.

Traders with diverse portfolio always prefer to take one percent risk in a trade.

This is a simple rule which tells trader should never put more then the 2% of his capital from the margin trading account on risk in a single trade.

Institutional trader and trader who are trading with the large sums even follow lower percentage to cater risk.

Use Stop Loss (SL) and Take Profit (TP)

These are two effective but most simple tools available to every trader. Effective implementation of these two offers better control over the margin trading account.

Especially when trader is dealing with the multiple positions.

Stop Loss is a tool (A pending order to exit from trade) which can exit you from the trade when your losses reach to specific value. It helps to limit the losses.

Take profit is used to book the profits when a specific level reached. If also eliminate the risk the price return to the negative area.

Calculate the expected Return in Margin Trading

You only can stay specific in your SL and TP when you calculate and decide it earlier so you can implement the same in your trade.

Diversify or Hedge

When you are handling a margin trading account there if you invest all of your money on one security it will potentially increase your risk.

And you are making yourself vulnerable to a big loss. Remember to diversify your portfolio or use hedging facility.

Use 1:3 Risk Reward

Knowing about to the risk-reward ratio can definitely improve your profitability in the market when you target 1:3 risk to reward with the margin trading if can recover your costs as well earn you nice returns.

Conclusion Bottom line on Margin Trading

Margin trading enable investor with the more buying power to invest in the market. But it is riskier then the other form of trading. While trading with the margin trading you may lose all of your investments or can double it multiple times.

Now let’s outline key points of Margin Trading

  • Applying for margin means borrowing money from a broker to purchase security.
  • Margin multiply your buying capacity.
  • An initial deposit requirement is there to start a margin trading specially for stocks.
  • You have to keep maintenance margin at required level.
  • Securities which are margin eligible act as a loan collateral.
  • You have to pay interest on borrowing/margin.
  • Not all the securities are margin eligible.
  • You must understand the margin agreement, as well as its implications.
  • If the maintenance margin is dropped broker will close your positions.
  • In case of margin call you have to add funds to your account or your positions will be liquidated.
  • Broker can sell your securities without say anything.
  • Leverage is a by-product of margin.
  • If you make right decision then with the margin trading account you can win big.
  • On the flip side while using margin trading account you can lose more money than you invested.
  • Margin Trading is not for everyone.
  • It is extremely risky.

Other Useful Resources

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What is Forex

How to trade Forex

Swing Trading Strategies

The Basics of Trading on Margin

 

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