As you may well already know, trading on margin means that you only have to put up a percentage of the value of an instrument in order to take a trade in it. Margin rates vary but sometimes can be extremely high such as 200:1. Trading on margin is part and parcel of the world of finance – so much so that we rarely stop to think about it. But when does margin trading make sense?
Risk management
First and foremost, to be effective in trading a highly leveraged product your risk management must be under strict control. Not taking your stop when the market gets to it, doubling up on losing trades in the hope that the market will come back or taking impulse trades can all elevate your risk to a level where your capital can evaporate in no time at all.
If you’re trading a highly leveraged product and have a small amount of capital in your trading account. It won’t take many trades to wipe you out. Indeed, this is why many people fail in their goal to be a consistently successful trader – because they are undercapitalized for the leverage that they are trading with.
Deposited capital
But there are benefits to margin trading if you have your risk under control. Not having to put down 100% of the cost of an instrument allows you to put the remainder of your capital to use elsewhere. It also helps you if you choose to trade with a larger percentage of your capital, to maximize the return on the number of prices that you take from the market.
Additionally in recent years, we’ve unfortunately seen some brokerage and clearing firms go belly up. The more capital you leave deposited, the more is at stake if something like this happens.
Product accessibility
Accessibility to products to trade is another big benefit. Just think about this for a moment – the E-mini S&P500 at many brokerages costs $500 in day trading margin. It is currently trading around the 2000 level. The value of this product by tick value (1 tick = 0.25 points = $12.50) is therefore (2000 / 0.25) x $12.50 = $100,000. $100,000!! Most people, especially newer traders, wouldn’t have the money to trade this product if margin didn’t exist and even those who do, wouldn’t be too keen on having to put up that much money in order to make $12.50 per tick. This is even though a reasonably sized move might be something like 1% of the value of the E-mini S&P500.
Short term trades
Whatever the timeframe you trade in is, there’s always opportunity to take a shorter term trade. If you’re a swing trader, this might mean taking a trade over an economic figure release. If you’re an intraday trader, it might mean taking a quick scalp at a level of support or resistance. But taking short term trades if all of your capital is tied up in longer timeframe trades is going to be difficult if not impossible without trading on margin.
When does Margin Trading Make Sense?
You must ask yourself some questions when deciding whether or not to trade on margin. How much trading capital do you have and how much should you be risking per trade in order to weather a drawdown as a result of adverse trading conditions? Are you effective in implementing your risk management strategy? If you can answer these questions adequately, then margin trading can provide you with excellent flexibility and a great way to maximize your profits.
Trade well.