Margin trading is a popular method used by traders all over the world. It can offer attractive opportunities, but as with any form of trading there are no guarantees and the level of risk must be taken into account before any decision is made. Trading on margin means using leverage, which has the potential to magnify profits or losses depending on the movements of the markets. If you're thinking about opening a margin trading account, you must have a solid understanding of what it is, how it works and the pros and cons.
Only then can you make a fully informed decision on whether margin trading is right for you, so find out more with FXCM's detailed guide.
Margin trading allows you to invest greater sums of capital than the equity available to you in your account. It involves you borrowing from your broker to improve your purchasing power in a bid to magnify your potential profits. The money you borrow is secured against the assets you invest in, and interest is charged. That means you will repay your broker more than the amount you borrowed in the first place. This is usually done when the assets you invested in are sold.
If you are weighing up whether to start trading on margin, you must familiarise yourself with some of these key terms:
- Minimum margin. This refers to the amount of money you need to deposit into your margin trading account before you can be in a position to start executing deals. Some brokers will require a larger minimum margin than others.
- Initial margin. The proportion of the buy price that you commit from your own funds. Regulations across various locations will stipulate how much you can borrow and, as with minimum margin, the limit can differ depending on the broker.
- Maintenance margin. This refers to the percentage of capital in your account that is yours when you are trading on margin. A typical maintenance margin is between 25-40%, which helps ensure your debts don't climb too high.
How does margin trading work?
To trade on margin, you need to invest a certain percentage of the purchase value. The remainder is covered by the capital you've borrowed from your broker and that ratio is referred to as leverage. So, if the leverage ratio is 10:1 it means you have to put up 10% of the total order value using your own funds. The leverage you are offered may change depending on your broker and the instrument you are trading. For example, FXCM offers 30:1 on major currency pairs, 20:1 on gold and major indices and 5:1 on individual equities. To further explain how margin trading works, we've included an illustrative example below.
How to calculate trading on margin
- Let's assume you want to purchase 10 shares in Company X at £500 each.
- The leverage is 5:1, so you commit £1,000 and your broker provides the remaining £4,000.
- If the share price in that company rises to £525, you stand to make a profit of £250.
- That's a return on investment of 25%, even though the share price has only risen 5%.
- Of course, the flip side of trading on margin is that your losses can be magnified too:
- If the company's price falls to £475 you stand to lose £250.
- All of this comes out of the equity in your account.
- So, in this instance, you would lose 25% of your available capital even though the share price only fell 5%.
What is a margin call?
A margin call occurs when the equity in your account falls too low for you to be able to meet the maintenance margin. This can happen if the value of assets you have invested in declines far enough, thus magnifying your losses and eating into your equity. Your broker will then require you to deposit enough capital to meet the maintenance margin.
Trading on margin: What can you use it for?
You can use margin trading to operate in a wide range of markets. Examples include:
- Forex: The buying and selling of currency. Also referred to as foreign exchange or FX.
- Shares: Purchasing a stake in a company, as outlined in the example above. Alternatively, speculating on future share prices by using derivatives.
- Indices: Speculating on the future performance of a group of assets within a specific exchange.
- Commodities: Trading based on the price of physical assets such as metals, energy and livestock.
What are the advantages of margin trading?
There are plenty of benefits to trading on margin. For example:
- Increased purchasing power: Opening a margin trading account enables you to invest more than what you're limited to when solely using your own capital.
- Amplified profits: That increased purchasing power means that if your trade proves successful, you stand to make a greater profit than you would through investing only your own capital.
- Repayment flexibility: Typically, you only have to repay the funds to your broker when you sell the asset. So, unlike other loans, there are no repayment schedules to meet.
- Diversification: Margin trading can increase your opportunities to invest in different markets thanks to the greater purchasing power at your disposal.
Is margin trading safe? What are the potential risks?
As with any form of trading, there are no guarantees when it comes to margin trading and there are risks involved:
- Multiplied losses: If the value of an asset falls sharply, you could stand to lose the equity you invested in the first place while still needing to repay the capital borrowed from your broker.
- Interest charged: Your broker will charge interest on the capital they lend you, which means you will end up repaying more than you borrowed in the first place. This is less of an issue if your trade is successful because the interest simply eats a little into your profit margin. But if the markets move against you, your losses will be exacerbated.
- Margin calls: These can also magnify your losses because they require you to deposit further capital into your account to meet the maintenance margin set by your broker.
- Potential liquidation: If you fail to heed a margin call, your broker could liquidate the assets you traded on margin and leave you with significant losses.
What's the difference between margin trading and futures?
You can use margin trading to trade futures. These are financial contracts where a buyer and a seller agree to trade an asset for a fixed price on a pre-agreed date. Futures contracts can be bought and sold directly, or they can be traded using derivatives via contracts for difference (CFDs). This means the buyer is merely speculating on future performance, rather than taking ownership of the underlying asset.
Is margin trading right for you?
If you are new to the markets, margin trading may not be the most suitable approach for you because of the high risk involved and the potential for your losses to be magnified. However, if you take the time to educate yourself through FXCM's insights plus additional research and analysis, you may find that you can start to build a strong understanding of how margin trading works.
Ultimately, the decision to enter into a margin trade is a personal one. You need to make sure you've weighed up all the potential risks and benefits and are fully aware of how the various outcomes could impact your account. Only when you've taken the time to consider all these factors will you have a better idea of whether margin trading is right for you.
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