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Margin Trading

Margin trading: If you thought online stock trading with your own money was a risk,online stock trading then trading  with other peoples is nothing short of stupidity. For the new trader this is the difference between driving a Ford, and then buying a Ferrari. They both do the much the same thing, but in very different ways. Press the pedal of the Ferrari, and you will be rocketed forward, probably straight into a brick wall, and hospital.

Margin trading is full of risks and certainly not for the beginner, but it is an important if dangerous part of trading, particularly in highly geared markets such as currency trading, where it would be almost impossible to trade without it. Sadly many new traders have little understanding of how margin trading works, and often confuse it with leverage ( even experienced traders do) which goes hand in hand with margin - so here is a simple explanation of margin, both the good and the bad!

Margin Trading: Introduction

Imagine for a moment that you have gone to the casino with friends, but unfortunately you only have £50 in your wallet. Your friend kindly offers to lend you another £50 for the evening. Full of confidence you advance to the tables and promptly lose the lot! In the space of a few minutes you have not only lost your own money but also your friends. Had you just lost your own money you would have lost 100% ( £50/£50). You have managed to lose 200% ( £100/£50). This is what trading on margin is all about. It is called leverage and both losses and gains are magnified enormously.

In essence, trading on margin is borrowing money from your broker to buy stocks and shares and use your investments as collateral. Unfortunately margin trading exposes you to substantially higher risks  and much bigger losses. You might ask why am I telling you all about it if it is so risky. The answer is twofold.  Firstly I want you to understand the risks involved, and that it is NOT for the novice investor. Secondly, there are several instruments and markets, that you can ONLY trade on margin. Part of the reason for suggesting that you do not enter spread betting before you have at least 2 years experience, is that this is one of these markets (you see there is method in my madness). Options and currency are two others that require margin.

Let's suppose you bought a stock at 10 USD and the price rises to 15 USD. If you bought the stock in a cash trading account ( i.e. your own money ) you would earn a return of 50% ( 5 /10). Now in a margin account your broker can lend up to 50% of the amount you deposit in the account. So suppose now you had bought this stock using a margin trading account. You would have put in 5 USD and the broker would have lent you 5 USD to buy the stock initially. It has now gone to 15 USD. You pay back the stock broker the 5 USD he lent you, and you have been left with 10 USD. Your profit is 5 USD, a 100% return on your money!! ( 5/5). So for a 50% increase in price, you have made a 100% return.

Margin Trading: Leverage Explained

Now let's look at the downside of margin trading - you have been warned. The most eloquent definition of leverage is the one provided by the National Futures Association “leverage is the ability to control large dollar amounts of a commodity with a comparative small amount of capital”.   In general forex brokers will offer leverage from 50 to 1 up to a suicidal 400 to 1.  If we take the example of a standard forex account where one contract equals 1 lot of $100,000 then at a leverage of 50 to 1 a minimum deposit of $2000 would be required to trade.  In effect for every dollar that we invest the broker would loan us 50 more.    It is easy to see why leverage is so attractive and yet so dangerous, particularly when you consider that in the equity markets the maximum leverage is just 2 to 1.

Now let's look at the equity markets - suppose the stock you bought on margin at 10 USD falls to 5 USD - you pay your broker back the 5 USD you borrowed, and you are left with ??? - correct - nothing - so on a 50% fall in value you have lost 100% of your capital!!! What you are looking at in the above examples are the effects of leverage. Leverage is a double edged sword, which amplifies both losses and gains to the same degree. Because leverage magnifies everything, it hugely increase the risk in your stock portfolio or currency trades. In addition to the above there are two other factors to consider:

1. Interest - Of course!!!! - you didn't think the broker lent you money for free ( oh you did ) - he has to eat as well you know!!!

2. Margin Call - If your margin account falls below very prescribed limits you will receive a margin call - this is the broker asking for more money to cover your losses. If this is not available immediately, your online stock broker has the right to close some or all of your positions in order to reduce your exposure to the market. This is likely to happen in particularly volatile markets. If you receive a margin call in my opinion you are out of control of your trading, and should stop immediately. Your stock broker will take action immediately if you do not respond.

Just to reinforce the point here are the percentage figures for you to consider, based on a 50% margin trading account.

% Decline in share or stock value Percentage Loss
10% decline in value 20%
20 % decline in value 40%
30% decline in value 60%
40% decline in value 80%
50% decline in value 100%
60% decline in value 120%
70% decline in value 140%
80% decline in value 160%
90% decline in value 180%
100% decline in value 200%

Now, just to finish off this subject I am going to leave you with a rule, which should perhaps be on the previous page. However I am going to put it here as it reinforces another point, and that is as follows :

Never trade with money you cannot afford to lose, and never ever borrow money to start trading.

Given that we have been talking about trading on margin I would like to clarify the above statement. The above rule is really two rules in one, but I'm sure you understand the point. Never borrow your online start up trading capital by using a credit card, re-mortgaging your house, borrowing from family or friends or any other source. JUST DON'T - you will fail because of the emotional pressures of using other people's money. You will have enough pressure just using your own!!

If you are new to investing and trading I strongly recommend that you stay away from margin trading as long as possible. When, and if, you feel ready, remember the risks, and also that you do not have to use the full 50%, you can start at a lower rate, so consider starting at 10% - you should still be able to sleep at night! Please just remember with margin trading the risks you are taking - you can easily lose all your online trading capital, and more!

Right, now lets take a look at spread betting which you will need to master in order to play both sides of the market.

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