Margin trading refers to the process of applying leverage to your trades. Whether it’s forex, stocks, indices, cryptocurrencies, or commodities – you can typically apply leverage on any asset class of your choosing. In doing so, you are effectively trading with more money than you have in your account. This is because you are borrowing the funds from your chosen broker, which in turn, will attract a financing fee.

In terms of how it works, you will need to choose the amount of leverage that you wish to apply to your trade. For example, let’s say that you have an account balance of $500, and you apply the leverage of 10x. In theory, this means that you are actually trading with a stake of $5,000. So, if you make 5% on the trade, your profits will be amplified from $25 to $250.

How does margin trading in the forex market work? - Quora

At the other end the spectrum, your losses will also be amplified. For example, if the above trade went down in value by 2%, your losses would be amplified from $10 to $100. Irrespective of how much leverage you decide to apply, you will need to put up a ‘margin’. This is like a security deposit that the broker holds until the trade is closed.

If effect, if the trade goes against you by more than you have in the margin, then the broker will automatically close your trade. This is known as being ‘liquidated’, and it means you will lose your margin in its entirety. This is why you need to have a firm grasp of how margin trading and leverage work, as you can lose a lot of money if you don’t have the required stop-loss safeguards in place.

Leverage

First and foremost, there is often a misconception that leverage and margin both refer to the same thing. Although they correlate to one another, there is a slight difference. In a nutshell, while leverage refers to the multiple that you plan to apply on your trade, margin refers to the upfront deposit the broker will require from you.

So, leverage is typically expressed as either a ‘ratio’ or a ‘multiple’. For example, this might be 5x and 5:1, or 10x and 10:1. For the purpose of simplicity, we’ll discuss leverage as a multiple, but just be aware that some brokers might display it as a ratio. Nevertheless, the amount of leverage that you decide to apply will dictate how much your trade is worth.

For example:

  • Let’s say that you are looking to go long on Apple stocks
  • You have $1,000 in your account, but you want to invest more
  • As such, you apply the leverage of 5x
  • This means that your Apple buy order is now worth $5,000

As per the above example, let’s say that later in the week Apple stocks increase by 10%. Ordinarily, you would have made $100 profit, as your balance is $1,000. However, as you applied leverage of 5x, we need to multiple this by 5. As such, you actually made a profit of $500.

With that being said, we also need to factor in what would happen if your Apple stock trade went the other way.

  • Sticking with the same example as above, you have a $1,000 buy order on Apple at a leverage of 5x
  • Later in the week, Apple stocks go down in value by 5%
  • Ordinarily, you would have lost 5% of $1,000 – which is $50.
  • However, you applied leverage of 5x, so your losses actually amount to $250

As you can see, leverage not only applies to winning trades, but losing ones too.

Margin

So now that you know how leverage works in practice, we now need to look at your margin requirement. In its most basic form, the margin is upfront security that the broker requires from you to be able to trade on leverage. In Layman’s terms, this simply amounts to the size of your trade without the leverage.

For example, let’s say that you have $500 and apply the leverage of 10x. Sure, the size of your trade equates to $5,000 – but, your margin is only $500.  As such, this is the amount that you will need to have in your account to get the trade on. It is then placed in your ‘margin account’ until the trade is closed.

In order to work out how much margin you will need to put up, you simply need to look at the multiple.

  • For example, if you want to trade with leverage of 10x, the required margin is 10% (1/10)
  • If you want to trade with leverage of 30x, you will need to put up a margin of 3.33% (1/30)

This is really important to understand, as your entire margin is at risk when you trade with leverage.

Liquidation

Leading on the from the section above on margins, we now need to discuss the meaning of ‘liquidation’. As noted earlier, this will occur if your leveraged trade goes against you by more than you have in your margin account.

For example:

  • Let’s say that you applied leverage on a buy order on GBP/USD
  • You staked $100 at a leverage multiple of 20x
  • This means that your trade is worth $2,000
  • Your margin of $100 amounts to 5% of the trade size
  • If your GBP/USD trade goes against you by 5%, the broker will liquidate the position
  • This means that the trade is automatically closed and you lose your $100 margin

As you can see from the above, you will be liquidated if the trade goes against you by 5% – which is the amount of margin that you put up.

In another example, if you placed a $1,000 order at a leverage of 2x, your margin would amount to 50% – or $500. As such, you would have a huge buffer of 50% before having your trade liquidated, which is much more risk-averse than trading at 20x.

Margin Call

It is important to note that you typically have the option of avoiding liquidation. Known as a ‘margin call’, your chosen broker will notify you when you are approaching your liquidation price.

For example, let’s say that you are trading the FTSE 100 at leverage of 25x. This means that your margin is 4%. Let’s then suppose that your trade goes against you by 3.8% – which is just under your margin balance of 4%.

Once you receive your margin call from the broker, you will have one of two options:

The first option is to do nothing. If the FTSE 100 continues to go against you and hits the 4% mark, your trade will be liquidated and the broker will keep your margin.

The second option is to add more money to your margin account. This will give you extra breathing space and prevent your trade from being liquidated – at least for the time being.

For example:

  • Let’s suppose that you originally put up a margin of $500.
  • You’re trading at a leverage of 25x, meaning you trade is worth $12,500.
  • You are approaching the 4% mark, meaning that you stand the risk of losing your $500 margin
  • As such you decide to add a further $500 into your margin account
  • In theory, this means that you have just bought yourself an additional 4%
  • That is to say, even if the original 4% liquidation is triggered, your trade will remain open as you added an additional 4% in the margin!

Margin Trading Fees

On top of your usual trading fees, margin trading comes with additional costs. At the forefront of this is overnight financing.

Overnight Financing

Regardless of how much leverage you decide to apply to your trade, you will always need to pay overnight financing fees. This is a fee charged by the broker for lending you the funds to trade on leverage. After all, you will be trading with more money than you have in your account – so it makes sense that this needs to come at a cost.

Crucially, overnight financing works like an interest rate on a loan. In the case of margin trading, you will need to pay a fee for each day that you keep your position open. As such, the longer you keep your leveraged trade in the market, the more you will need to pay. This can have a direct impact on your ability to make gains, so it’s really important that you assess how much you will need to pay.

The good news is that most of the brokers that we recommend display your overnight financing fees in dollars and cents. This means that you get a full break down of how much you will need to pay each day. In some cases, you will need to pay a premium for keeping the position open over the weekend. This will depend on the asset you are trading, as well as the specific broker you do this with.

It is important to note that your overnight financing costs will be deducted from your margin balance. With this in mind, you will inch closer to your liquidation price for each day that you keep the position open.

Other Trading Costs

  • Spread: This is the difference between the buy and sell price of your chosen asset. The higher the spread, the more you will need to indirectly pay in fees.
  • Commission: While some brokers charge trading commissions, others don’t. If you are charged, then this is typically a percentage against the amount you trade. For example, a 1% commission on a $200 trade would cost you $2.

Stop-Loss Orders

Installing a stop-loss order will be the difference between you losing a small amount of money on your leveraged trades or your entire margin. For those unaware, stop-loss orders allow you to specify an exact price that you want the trade closed at.

For example, let’s say that you apply the leverage of 10x on a $2,000 trade. This means that you will lose your entire margin if the trade goes against you by 10%. You obviously don’t want to lose 10%, so naturally, you install a stop-loss order.

If you want to mitigate your losses to 1%, then you would need to reflect this in your stop-loss trigger price. For example, if you are trading Disney stocks at $100 per share, your stop-loss price would need to be positioned at $99 on a buy order, and $101 on a sell order.

If and when your stop-loss price is triggered, the broker will close the position automatically. Ultimately, this will prevent you from losing huge amounts of money when trading on margin.

Once you receive your margin call from the broker, you will have one of two options:

The first option is to do nothing. If the FTSE 100 continues to go against you and hits the 4% mark, your trade will be liquidated and the broker will keep your margin.

The second option is to add more money to your margin account. This will give you extra breathing space and prevent your trade from being liquidated – at least for the time being.

For example:

Let’s suppose that you originally put up a margin of $500.
You’re trading at a leverage of 25x, meaning you trade is worth $12,500.
You are approaching the 4% mark, meaning that you stand the risk of losing your $500 margin
As such you decide to add a further $500 into your margin account
In theory, this means that you have just bought yourself an additional 4%
That is to say, even if the original 4% liquidation is triggered, your trade will remain open as you added an additional 4% in the margin!

Ultimately, although adding more margin will prevent you from being liquidated in the short-term if the trade continues to go against you and your trade is closed by the broker, the amount you will lose will be even greater.

Note: You likely won’t actually receive a margin ‘call’ in the truest form. On the contrary, you will be notified via an email or mobile notification.

Margin Trading Fees

On top of your usual trading fees, margin trading comes with additional costs. At the forefront of this is overnight financing.
Overnight Financing

Regardless of how much leverage you decide to apply to your trade, you will always need to pay overnight financing fees. This is a fee charged by the broker for lending you the funds to trade on leverage. After all, you will be trading with more money than you have in your account – so it makes sense that this needs to come at a cost.

Crucially, overnight financing works like an interest rate on a loan. In the case of margin trading, you will need to pay a fee for each day that you keep your position open. As such, the longer you keep your leveraged trade in the market, the more you will need to pay. This can have a direct impact on your ability to make gains, so it’s really important that you assess how much you will need to pay.

The good news is that most of the brokers that we recommend display your overnight financing fees in dollars and cents. This means that you get a full break down of how much you will need to pay each day. In some cases, you will need to pay a premium for keeping the position open over the weekend. This will depend on the asset you are trading, as well as the specific broker you do this with.

It is important to note that your overnight financing costs will be deducted from your margin balance. With this in mind, you will inch closer to your liquidation price for each day that you keep the position open.
Other Trading Costs

On top of your overnight financing fee, you will also need to take the spread and trading commission into account.

Spread: This is the difference between the buy and sell price of your chosen asset. The higher the spread, the more you will need to indirectly pay in fees.
Commission: While some brokers charge trading commissions, others don’t. If you are charged, then this is typically a percentage against the amount you trade. For example, a 1% commission on a $200 trade would cost you $2.

How to Mitigate the Risks of Margin Trading

So now that you know the underlying risks of margin trading, we now need to look at some of the methods you can take to mitigate your losses. After all, even seasoned traders encounter regular losses, as this is just the nature of the online investment space. With that said, skilled traders know how to reduce these losses by installing sensible stop-loss orders.
Stop-Loss Orders

Installing a stop-loss order will be the difference between you losing a small amount of money on your leveraged trades or your entire margin. For those unaware, stop-loss orders allow you to specify an exact price that you want the trade closed at.

For example, let’s say that you apply the leverage of 10x on a $2,000 trade. This means that you will lose your entire margin if the trade goes against you by 10%. You obviously don’t want to lose 10%, so naturally, you install a stop-loss order.

If you want to mitigate your losses to 1%, then you would need to reflect this in your stop-loss trigger price. For example, if you are trading Disney stocks at $100 per share, your stop-loss price would need to be positioned at $99 on a buy order, and $101 on a sell order.

If and when your stop-loss price is triggered, the broker will close the position automatically. Ultimately, this will prevent you from losing huge amounts of money when trading on margin.

Margin Trading Limits

When it comes to margin trading limits, this will depend on a number of variables – such as your whether you are a retail or professional client, the type of asset you are trading, and the broker you are using.

 

 

 

 


0 Comments

Leave a Reply

Your email address will not be published. Required fields are marked *