Why margin matters in trading?
Margin, or leveraged, trading can lead to gains proportionately much larger than the investment. However the same applies to losses.
IN A FEW WORDS
Leverage (margin) trading Margin level Automatic orders Conditional orders
4 min reading
Leveraged trading (also known as trading on margin) allows traders to potentially achieve larger returns for a relatively low investment. However, it comes with risks and just as gains can be in much higher proportion to the initial investment, so can losses. Learning to manage risk effectively when trading with margin can help keep you in the black.
Leveraged trading allows you to take a large exposure to an asset with a smaller outlay. In doing so you are effectively borrowing money from the broker using a margin account. The loan is secured by the assets held in the account and interest will be payable. If the trade outperforms the cost of the interest then the trader comes out ahead but, if the trade performs poorly, they must pay off the interest debt in addition to losses from the drop in value of the investment.
Margin levels will vary and some brokers, including Fineco, will let you vary the level of margin depending on the asset traded and individual preferences. On our platform, for example, Amazon shares can be traded on a 2% margin. That means if you want £30,000 worth of exposure, you only need to make an upfront investment of £600. If the price rises from £3,000 to £3,200, you’ve made £200 X 100 = £2,000. If it goes from £3,000 to £2,800, you’d need to find £1,400 (£2,000 less the £600 you’ve already paid).
In order to keep a trading position open you must make sure your margin account is adequately funded. The amount needed will vary but will be a percentage of your overall exposure. If your account falls below the agreed level the broker will usually ask for a ‘margin call’. In other words, a payment to keep the trade open.
Famously, this was the undoing of rogue trader Nick Leeson, who bankrupted the blue-chip Barings Bank in the 1990s. The margin calls on Leeson's positions on the Singapore Futures Exchange reached over S$300m.
If you do not meet the margin call, your broker can close out any open positions and can choose those positions it liquidates. This is why the most important part of any leveraged trading strategy is to understand your potential losses, potential margin calls and what you can afford to lose. Unhedged open positions with potentially infinite losses are a bad idea no matter how convinced you are that the trade will eventually go your way. Your trading strategy should include a strategy to deal with unexpected – pandemics, earthquakes or financial crises.
Strategies for managing risk
Setting automatic orders is a handy tool to manage your exposure even when you’re away from your computer. Two straightforward tools are ‘stop losses’, which protect your position by limiting your losses when the price hits a set threshold and ‘take profits’, automatically selling once you’ve made a certain level of profit.
You can also use conditional orders. These are activated when a series of conditions, set by you, are met. On the Fineco platform, up to 30 conditional orders can be used at the same time. It is also possible to use OCO ("one cancels the other") conditional orders, which set up two actions for the same security; the execution of one forces the cancellation of the other. Related orders let you set up a conditional order that depends on the performance of another financial product.
A trailing stop operates like a stop loss but incorporates changes in a security’s price. It can pick up positive or negative momentum in a company’s share price, by looking at the latest high/low of the security. From there, it adapts the stop. You need to decide in advance how much you are willing to let the price drift.
Another way to embed risk management in your trading strategy is by observing the correlation between different asset classes and putting hedging strategies in place. For example, gold often rises as the Dollar falls. It is an imperfect hedge but including some gold may protect you against losses if you’re betting on Dollar assets rising. In the oil sector, you might go long on BP and shortShell, for example, which should mitigate the impact of the oil price, leaving you with just exposure to company performance.
Above all, when trading on margin, don’t let your emotions get the better of you. Allowing large losses to build up, betting more in the hope of recouping losses, chasing performance and ignoring risk are all ways to lose money quickly. Do your homework and keep an eye on the prices you’re paying to trade. In that way, you can make leveraged trading work for you.
The margin calls on Leeson's positions on the Singapore Futures Exchange reached over S$300m: mbaknol.com/business-ethics/case-study-nick-leeson-and-the-collapse-of-barings-bank;
Information or views expressed should not be taken as any kind of recommendation or forecast. All trading involves risks, losses can exceed deposits.
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