Margin is commonplace in the world of finance and trading. It can be found when trading stocks, forex, futures and options and plays a pivotal role in the success or failure a trader experiences. But what does it mean to trade on a margin?
Borrowing from your broker
Trading on margin is basically just a way to make the most out of your money. Depending on the specific broker and product, it might mean that you can use your $1,000 to trade $50,000 worth of a product.
To do so however, someone has to put up the money in order to make sure that your losses are covered in the event that things go really wrong. This is going to be your broker. So in effect you are borrowing from your broker when you trade on a margin. They are able to do this with decent amounts of capital and sophisticated risk management systems.
Futures market exchange margin
There’s also exchange margin when dealing with futures exchanges – this is basically the percentage of the value of a product that they require as a minimum to trade it. It comes in the form of initial margin which is the amount required to initiate a position and maintenance margin which is the minimum amount per contract in total you are expected to maintain in your account in order to hold the open position. These margins are usually much higher than broker day trading margins and only come into effect if you hold a position across sessions.
Leverage – Amplifies winners AND your losers
The impact of trading on margin is your winners and your losers are amplified. So if you took a winner where a particular market’s value changed by 0.5% and you were trading with 100:1 leverage, you could potentially increase your equity by 50%. But the same goes for if you were to lose when trading margin and that’s why it’s a double-edged sword.
A margin call is something that you’ve probably heard of. It happens when you are in a position and the total value of your account should the position be liquidated, falls below the margin requirement. It usually costs you money if the broker takes you out of the position and means you do not have the opportunity to exit the trade where you choose. A margin call is something that you want to avoid.
You may lose all or more of your initial investment
In some cases, it may also be possible to lose all or more of your initial investment. “How?” I hear you say. Well, generally speaking, brokers are pretty good at protecting against this because apart from anything, it could end up costing them a great amount of money if they don’t. Their systems tend to be pretty good and if you do drop below margin, in many cases they will blow you out of your position. If however, there is a freak move and they are unable to take you out before the market moves so far that your account goes negative, you will be liable for the outstanding debit.
Trading on margin is a great way to put your money to work especially if you are a consistent trader. It does however come with a significant amount of added risk. Trading on a margin must be understood and respected.