Margin trading means you don’t pay the full price of the asset. Instead, you only pay a percentage of the underlying value. The broker lends you the rest of the money for your trade.
Trading on margin allows you to leverage gains when the price of an asset moves the way you predicted – or lose more than your deposit if a trade goes against you. Safeguard ‘stops’ can be put in place to limit your losses. However, before you start trading there are some basic requirements.
Different names for margin
First, let’s look at the concept of the initial margin. This goes by a variety of names, including ‘deposit margin’. It’s the start-up deposit. This value will be enough to start trading and hold an amount in reserve to deal with any losses or share price swings.
The key is that the assets in this account can be sold or taken by your broker to repay your debts if you fail to top up the account when required to do so. Potentially you could lose everything – and still owe the broker more!
Maintenance margin
If the trades go against you, you may need to fund your account to meet what’s called your maintenance margin (or is sometimes known as minimum maintenance margin). Your maintenance margin is meant to be enough to cover potential losses.
Margin requirement
The money for each trade is the required margin or margin requirement.
How much will be required exactly will depend on the assets you choose. It is calculated as a percentage of the asset’s price and is called the margin ratio.
In CFD trading, indices and popular commodities such as gold, this amount might be 2%; with big name shares 5%; and for riskier shares 20%.
If you have several positions open (many different trades) at the same time, the combined total of the required margin for each trade is called your used margin. Any money remaining to open new trades is called your free margin.
Margin call
If one trade goes spectacularly against you, or if several edge against you, you could face losing more than the required margin that you paid for all your trades – your used margin. This would mean the losses eat into your maintenance margin.
If your position is still open, meaning still trading, these losses are theoretical. Your asset might recover and you could be quids in.
However, as trades are often monitored electronically, your broker might ask you to top up your maintenance margin, just to be safe. This is called a margin call, and it could happen as soon as your maintenance margin drops below 100% of the figure agreed with the broker.
Your broker will certainly send you a reminder if it drops to 80%. You should top up your maintenance margin account if this happens.
Close out
If you have failed to respond to a margin call or, despite topping up your maintenance margin account your positions continue to worsen and your maintenance margin reaches 50%, your broker will begin to close out.
This means your broker will try to close your open position as fast as possible using whatever prices are available at that time in the market. You will miss the opportunity for your trades to bounce back; they will be closed in the loss-making position they are in.
The worst-case scenario is that you have a trade in an asset whose price is falling rapidly. For example, a share in a company that has announced it’s lost its biggest customer could halve in value in a day.
There might be few buyers and your broker might have to sell in several small batches at lower and lower prices, compounding your losses.
You could lose your entire maintenance margin and still owe money, unless your broker has some kind of guarantee to prevent this happening (it’s worth checking!).
Benefits and risks of margin trading
The value of the margin account, then, is that it allows you to run a position while giving you leeway, allowing a share price to fluctuate – even if it moves against you sharply.
Provided you have sufficient funds in your margin account, you can wait until the share price moves back in your favour. If you don’t, the broker can close your position and you lose your money.
