You can earn much more than usual on the stock exchange if you use borrowed funds. Or - lose all the money and still remain due to the broker. We tell you what an investor needs to know about margin trading
What is margin and what is it like?
When an investor wants to spend more money on a transaction than he has, he can borrow money from a broker. Then the collateral will be your own funds on the brokerage account — they are blocked as a kind of security deposit. This amount is called the margin. The margin is recalculated every time a trader opens a position.
Two types of margin are calculated: initial and minimum.
Initial margin is the initial collateral for making a new transaction. It is calculated by multiplying the asset value by the risk rate.
The risk rate is the probability of a change in the price of an asset on the exchange. As a rule, the higher the volatility of the instrument, the higher the risk rate. Brokers usually publish risk rates on assets on official websites. Please note that the risk rates for short trades are always higher than in long ones.
Minimum margin - the minimum security to maintain a position that you have already opened. Usually, the minimum margin of one liquid asset is equal to half of the initial margin.
To calculate the initial and minimum margin for the entire portfolio, you need to add up the initial and minimum margin for each liquid asset. If the value of the liquid portfolio falls below the initial margin, you will be able to buy back some of the assets in an uncovered position, but you will not be able to enter into new transactions.
A liquid portfolio is the total value of the currency and liquid securities in your brokerage account. Shares of foreign companies, currency and Eurobonds are accounted for in rubles at the current exchange rate.
But if the value of the liquid portfolio falls below the minimum margin, then the broker will have the right to forcibly close some of your positions so that the value of the liquid portfolio does not fall to zero and go into negative territory. The broker has the right to choose the positions that he considers necessary to close.
Before closing your trades, the broker will send a notification about the need to top up the account with the required amount. Such a message is called a margin call.
Read more: What are Eurobonds?
What is long trading?
A long position is a transaction based on the growth of quotations. The point of a long position is to buy shares while they are cheap, and sell them when they become more expensive. Traders can participate in long-term transactions not only with their own funds, but also with borrowed funds - that is, provided by a broker.
In this case, the potential profit increases - but the losses from unsuccessful transactions are completely borne by investors. Example: you bought ten shares of Tesla for $700. A few days later, they sold all the securities at $800 per share. Then your profit will be $1 thousand.
If you used margin trading and the broker gave you the opportunity to buy twice as many shares, then the amount of your purchase would be $14 thousand, and the profit would be $2 thousand. As you can see, when using borrowed funds, the investor's profit turned out to be twice as much. But, of course, you need to take into account the commissions for transactions and the transfer of positions for several days.
Now let's consider the negative scenario of the development of events: Tesla shares fell to $600. Your loss will be $1 thousand if you used only your own funds. But if you bought them with a leverage of x2, the loss would be equal to $2 thousand.
As can be seen from this example, margin trading increases not only potential profitability, but also losses. Before using leverage trading, you need to learn how to control risks, not be afraid to fix small losses ,and also use take profit and stop loss.
Read more: Forex broker: how to choose a good broker
How does margin trading work in long?
Let's say we have ten shares of Tesla on our brokerage account, the market value of one is $700. There is $1 thousand on the account, and we want to buy some more Apple securities.
First, the broker will calculate the size of our liquid portfolio. It will be: $700*10 shares + $1 thousand. = $8 thousand.
Next, the broker will calculate the initial and minimum margin.
The initial margin in our example will be calculated as follows: $700*10 shares*50% (let's assume that this is the long risk rate for Tesla shares) + $1000*10% (let's assume that this is the long risk rate for the dollar) = $3.6 thousand.
The minimum margin is equal to half of the initial one, that is, $1.8 thousand.
Next, when we want to buy Apple shares, the broker will calculate the maximum transaction amount. It is calculated as follows: (liquid portfolio-initial margin) / long risk rate on the asset (in our case, Apple)
In our example, the transaction limit will be equal to: ($8 thousand — $3.6 thousand) / 25% (let's assume that this is the long risk rate on Apple shares) = $17.6 thousand.
Let's assume that the market price of Apple shares is now $100. This means that we will be able to buy a maximum of 176 Apple securities. But let's say we decided to buy only 100 shares. Then this is what our portfolio will look like:
- 10 shares of Tesla, the total value is $7 thousand.;
- 100 shares of Apple, the total value is $10 thousand.;
- "minus" $9 thousand (we had $1 thousand and we bought Apple shares for $10 thousand in debt).
After that, the broker will recalculate the value of our liquid portfolio, its initial and minimum margin. This happens every time the composition of the liquid portfolio or the price of the assets that are included in it changes.
As already mentioned above, if the value of the liquid portfolio is higher than the initial margin, then we will be able to conclude new transactions. If it is lower than the initial, but above the minimum margin, then we will be able to buy back some of the assets, but not enter into new transactions. If the value of the liquid portfolio falls below the minimum margin, the broker will have the right to forcibly close part of our assets.
And how does short trading work?
You can earn money not only on the growth of the value of shares, but also on their fall. Imagine a situation: Microsoft shares are trading at $200, but we believe that the price is too high and the securities are about to fall, but we do not have these shares in our portfolio.
Then we borrow shares from a broker on the security of cash, and he sells them on the market. Next, we wait for the stock to fall, for example, to $180, and buy. When buying shares, they will automatically return to the broker (remember that we borrowed them), and the difference between selling and buying will be our profit, in this case — $20.
How it happens technically: when we sell shares that we do not have, the line "minus one Microsoft share"is formed in the portfolio. Also, the account receives funds from the sale — $200.
All calculations regarding the minimum and initial margin, as well as the liquid portfolio are similar to trading in long, but the risk rate takes the value of "short".
We pay a certain amount for each day of using the broker's assets, you need to get acquainted with the conditions of margin trading at the broker. However, this also applies to long-term trading, so margin trading is better used for short-term transactions.
Trading in short is much more risky than in long. In the case of a short game, the mathematical expectation plays against us: the shares can fall to 0 as much as possible, that is, minus 100%. And they can grow indefinitely, and 100%, and 200%, and even 500%. When trading in short, the investor puts himself in a deliberately dangerous position, so it is even more important to assess his risks in advance, determine the maximum possible losses on the transaction and set a stop loss.
Read more: Long-term Forex trading
Pros and cons of margin trading
- a larger amount of potential profit due to opening positions using borrowed funds;
- the possibility of trading not only for an increase in the price, but also for a decrease due to short trades.
- the amount of loss increases in case of an unsuccessful transaction;
- not all instruments can be shorted by the broker;
- you must pay a commission for transferring an uncovered position (even on non-working days of the exchange);
- if the value of the liquid portfolio falls below the minimum margin, the broker can forcibly close positions.