Margin trading is a way for traders to use leverage for their exposure to the financial markets, such as indices, forex, cryptocurrencies, commodities and stocks. It allows them to trade larger amounts by depositing a smaller initial outlay.
When using margin trading, you only need to deposit a percentage of the full value of the trade to open a position. This deposit, or initial outlay, is known as the margin requirement.
What is margin?
When trading on margin, you can invest more than the money that you already have in your trading account with your broker. You borrow money from your broker to leverage your trades and get higher returns.
It is important to remember that with margin trading, profits and losses are based on the full value of your trade. Margin trading can magnify gains, but it can also significantly magnify losses if the trade moves against your predictions. As a result, it is possible that you could lose more than you deposit. Margin trading can be a double-edged sword, so it makes sense to research the markets, build an effective strategy, and create your strategy template before you start trading.
CFD trading is a popular form of financial derivative trading that enables traders to trade on margin.
Buying on margin
When buying on margin, the broker allows you to deposit a percentage of the full value of the trade in order to open a position. This means you can make your capital go further.
Buying on margin example
If the margin rate (or requirement) for an instrument was 5%, and you wanted exposure to a position worth $1,000, you would only need to deposit $50 in order to open the trade. This means that if the trader makes a profit from the trade, they would potentially be able to make a large profit having deposited just a percentage of the full trade value. If they make a loss, however, the loss will be based on the full value of the position and could wipe out all of their capital. Margin trading is available across a wide range of asset classes, including currencies, commodities, indices and shares.
Selling on margin
Selling on margin means that the broker allows the trader to deposit a fraction of the full value of the trade. Similar to buying on margin, the trader might be able to make huge profits having only deposited a percentage, and in the case of a loss, the latter would be based on the full value of the position and could extinguish the whole capital.
Margin trading vs short selling
Short selling is a trading strategy where traders can sell shares that they don’t possess with the hope of profiting from falling share prices. They can do this with a margin trading account, as this may magnify the profits if the trade is successful. However, this can also magnify the losses.
How to calculate margins in trading
Different brokerages have different margin rates for certain instruments. As a general rule, the higher the volatility for a particular instrument, the higher the margin requirement is likely to be.
The trader must ensure that there are sufficient funds in their account to meet the margin requirements. It is important to learn how to calculate the margin requirements. The margin requirement is the percentage of funds an investor must have in their account at all times for the relevant trade, in order for that trade to remain open. Find out more about our CFD margins.
It is also worth calculating ROI (return on investment) when trading on margin. Return on investment is a type of performance measure. It is used to try and work out the efficiency of an investment. ROI measures the amount of return on an investment, relative to the investment’s cost. ROI = return of an investment/cost of the investment.
How does margin trading work?
Margin trading means that traders only need to put down a deposit to open a position, which gives traders more buying power and can maximize both profits and losses. Losses are based on the full value of a trade, so it is important to think about how much capital you are willing to lose per trade.
Should markets move in the opposite direction of your bet, you could end up losing all of your capital. Therefore, using risk management tools like stop-loss orders is a way to minimise the risk of experiencing a margin call. Before entering a trade, you should make sure that you understand the margin requirements.
A margin account can be used to make sure a trader is diversifying their portfolio. With margin trading, you can also take a short position on assets and therefore use it as a way to hedge an existing portfolio.
How does margin trading magnify profits and losses?
As mentioned earlier, margin trading can amplify losses as well as gains. High volatility in the market could result in huge movements against you. A trader could easily end up losing all of their capital, and more, if the markets unexpectedly move in the opposite direction.
It is worth remembering that you don’t own the underlying asset when trading CFDs. This means that the process works differently to buying stocks, currencies or commodities in the underlying market. With CFD trading, dividends on shares are adjusted whenever a company goes ex-dividend. This means, if you hold a CFD position in a company where you don't own the underlying share, and that company announces dividends, your account would be credited or debited on the day the stock goes ex-dividend. In effect, this means that you would not lose or gain anything from the dividend adjustment in the underlying instrument.
What is a margin call in trading?
When trading on margin, you could also be subject to a "margin call". If the value of a traders' position drops below the margin requirement. The broker would then require the trader to deposit more funds, or the position could automatically be closed. Even if one particular trade is profitable, if the net effect of all of your open positions requires you to deposit additional margin, but you fail to do so, your profitable trade could be automatically closed. The client will also be liable for any deficit on their account.
Margin trading can be tricky in times of market volatility and it is important to ensure that the company you are trading with is fully regulated.
Benefits of margin trading
The benefits of margin trading include being able to leverage your exposure to the markets. It is a more efficient use of your capital because you can trade without having to deposit the full value of the position you wish to open. As all of your money is not tied up in one transaction, you can use it for other investments. Remember, that while you can make large gains, you can also make large losses from a small initial outlay.
Consequently, it is important to consider your marginal trading outcomes. Margin trading is a good way of diversifying your portfolio. For example, you may be too heavily invested in a few shares or sectors that are quite closely related, or have a positive correlation. These shares or sectors are likely to have a tendency to experience similar rises or falls in price.
Your margin account could be used to add positions in other shares or asset classes (forex, indices, commodities and treasuries) that are negatively correlated. This means that when some shares in a portfolio are losing money, other non-correlated shares are likely to be gaining or will not move at all. This can potentially reduce losses and would improve your portfolio diversification.
It is also possible to hedge your existing portfolio through margin trading. For example, let’s say you hold a long position in the underlying market for a particular stock or commodity. In the event these prices start to fall in the short term, you could consider hedging the downside risk without closing out your trade. To do this, you could use your margin account to short sell the same stock or commodity and safeguard your underlying position against short-term falls.
Margin trading platform
We require our clients to trade on margin, or with leverage, on all positions that they open. This increases your exposure to the financial markets, with the chance to maximise profits. However, remember that losses can be magnified to an equal extent if the trade is not successful. Therefore, we suggest that you put in place an efficient risk management strategy before trading the live markets.
Our online trading platform, Next Generation, offers traders the chance to practise first with virtual funds. This means that you can familiarise yourself with our platform and execution and order types. Register below for a chance to explore our demo trading account.