Margin trading allows traders to buy more stocks than they would normally be able to normally by borrowing money from their broker. While this can amplify gains, it also increases risks if trades go the wrong way. This comprehensive guide covers everything a beginner needs to know to get started with margin trading.
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What is Margin Trading?
Margin trading refers to the practice of using borrowed funds from a broker to trade financial assets. It essentially allows the trader to open larger positions without having to put up the full cost of the trade. The margin is the amount the trader must have in their account to cover potential losses.
For example, if a trader wants to open a $10,000 position but only has $1,000 in their account, the broker may permit a 10:1 margin arrangement. This means for every $1 the trader has, they can trade up to $10 worth of assets. So with $1,000, the trader can control a $10,000 position.
How Does Margin Trading Work?
When a margin trade is opened, the broker lends the trader the extra capital needed to meet the margin requirements and open the larger position. The trader must have a minimum amount of equity in their account to cover potential losses on the trade.
Here is an overview of how margin trading works:
- Trader deposits $1,000 into their margin account
- Broker permits 10:1 margin, meaning they can trade up to $10,000
- A trader wants to buy $10,000 worth of stock
- Broker lends trader $9,000 to buy the shares
- The trader controls $10,000 position with $1,000 equity
If the share price rises, the trader earns the profit on the entire $10,000 position. However, if it drops, they can incur losses greater than their $1,000 deposit if the losses exceed the equity in their account.
How Margin is Calculated?
The margin is the amount of equity the trader must have in their account to open the leveraged position. The margin requirements are set by the broker based on the asset being traded.
For example, the margin for mainstream stocks may be 10-25% while highly volatile assets have higher requirements.
The margin can be calculated as a percentage using this formula:
Margin % = (Equity / Position Size) x 100
- Equity = $1,000
- Position Size = $10,000
- Margin = ($1,000 / $10,000) x 100 = 10%
So the trader must have 10% equity to open the position. The margin requirements must be maintained throughout the life of the trade. If the account equity falls below the margin rates due to losses, the trader will need to deposit more funds or close part of the position to restore the margin level. This is known as a margin call.
Common Margin Trading Strategies
Here are some trading strategies that are well-suited to margin accounts:
- Long-term trend-following – Margin accounts allow traders to hold leveraged positions in major trends for greater profit potential. More capital can be deployed riding trends.
- Short-term swing trading – Active short-term traders can leverage swing trades lasting days or weeks. More setups can be traded at once to amplify near-term moves.
- Pairs trading – Pairs trading involves taking a leveraged long/short position to benefit from the convergence of the prices of two historically correlated assets.
- Arbitrage strategies – Seeking to exploit small, short-term price discrepancies between related securities can benefit from low-risk margin leverage.
- Intraday scalping – For very short-term traders, leverage allows greater position sizes scalping small intraday moves across multiple assets or contracts.
Proper use of these strategies relies on sound risk management principles to avoid excessive losses. Traders should employ tight stop losses, prudent position sizing, and ongoing evaluation of the risk-reward payoff of trades.
Tips for Managing Risk with Margin Trading
Margin trading can provide great opportunities but also exposes traders to greater risks.
Here are some tips for minimizing risk:
- Only trade with reputable brokers with strong financial standing to reduce credit risk. Avoid thinly capitalized brokers.
- Use only the minimum effective amount of leverage necessary to capture your desired position size. Don’t take on excessive leverage.
- Diversify across multiple assets and sectors to avoid having too much exposure to one volatile trade.
- Scale position size appropriately to reduce risk rather than maximize leverage.
- Set stop losses on every trade to limit the downside. Use trailing stops to lock in profits as the market moves favorably.
- Closely track your overall margin balances and equity. Know your broker’s margin call policy and maintain a buffer.
- During periods of above-average volatility, reduce leverage when there is a higher likelihood of triggering forced liquidations.
- Avoid holding excessively leveraged positions overnight or over weekends when risk is higher.
Following prudent margin trading risk practices requires discipline but can lead to success over the long term.
What is the typical margin interest rate?
Most brokers charge an ongoing margin interest between 5% – 10% in addition to the baseline fees to maintain a margin account.
What happens in a margin call?
If your account equity falls below the margin maintenance requirements, the broker can forcibly liquidate your positions to pay back the leveraged amount.
What securities are eligible for margin trading?
Brokers generally allow margin trading on stocks meeting certain liquidity thresholds. Traders can trade options, futures, and FX pairs on margin.