Investing in a business requires immense business intelligence. Otherwise, it can lead to unwanted trouble, mainly if the business field isn’t your expertise. Therefore, choosing your investment strategy wisely is critical to avoid bigger damages.
Margin trading allows you to pay a specific percentage of the investment cost. It could also be a percentage of the margin. So, investors can earn profit from asset price fluctuation. These fluctuations are sometimes unbearable for investors if they choose other forms of trading.
While margin trading can greatly increase the capital available to make trades and boost the returns on investments, it also doubles the risk of potential losses and is riskier. We have you covered if you want a comprehensive overview of how margin trading works. We will explore the key techniques to help you earn better profits and assess risks.
What’s Margin Trading?
Margin Trading is a way to leverage your existing funds to purchase more assets. It allows you to use your cash as collateral against your trades and can be used to increase the number of assets you want to buy or sell.
You have to pay back the loan before you can sell your investment. If the price of your asset goes down significantly and the value of your collateral doesn’t cover the loan amount, you have to add more cash (or other assets) to make up for the difference.
Typically, a margin is defined by leverage and leverage ratio. These parameters have a direct relation with margin. Here is a quick illustration of the leverage ratio and margin relationship:
Margin Trade Limits
Margin trade limits dictate how much you can borrow from the broker. It depends on your account size and the account maintenance margin. The account size and maintenance margin refer to funds used to cover potential losses.
For instance, if you have a retail account, you can have maximum leverage between 30:1 to 2:1. Moreover, your broker would recommend maintaining a margin that can help fight potential risks later. If there is insufficient money to cover the risk, you may be eligible for a lower leverage ratio.
In worse cases, you might be put on a margin call. In a margin call, brokers will ask you to top up your account, or you may need to close the trade. Additionally, investors may experience a margin closeout.
A Quick Look at Trading Margin Mechanism
Margin traders use leverage to magnify their gains to pay the interest on borrowing. However, this also magnifies the risk of loss, and you must regularly meet a maintenance margin required to keep the position open.
For instance, if you trade stock worth $100 and you want to buy ten shares, you will need to deposit $1000. However, if there is a margin trade of 5:1, you will only pay $200 to open a position. The broker will provide the remaining amount.
Now, if the stock prices increase, say $110, you will earn $100. It’s simple math. Multiply the difference in the new and old stock prices with your number of shares. In this case, you have a profit worth 50% of your initial deposit.
Similarly, if the price drops to $95, you lose $50 from your overall deposit. This figure shows a 25% loss of your deposited amount when the stock price decreases by just 5%.
Example of Margin Trading
The following margin trading example should help understand the topic more effectively. Consider the following situation. Suppose you have $50 in your bank account. If you invest it in stock CFD trading, a 5:1 leverage means you can trade $250 of your assets for every dollar of your preferred margin, having a 20% total value of your trade.
For each dollar you spend, the broker will top $5. Hence, your $50 investment becomes $250. Likewise, for a 10:1 leverage ratio, you get a 10% margin. Hence, you can trade $500 as every dollar will represent only 10% of your total trade value.
What is Maintenance Margin or Credit Limit?
The maintenance margin is the minimum amount of equity that must remain in your account before your position can be liquidated. Moreover, it is mostly set on a per-contract basis and differs from exchange to exchange.
Your margin balance is more than just the required margin. First, you need to have sufficient backing in your account. The maintenance margin is the amount you don’t invest in trading. Instead, it’s used to cover the trading losses.
The credit limit or maintenance margin depends on the trade value and performance record. Typically, the overall margin should cover 100% of your trading loss. That’s why the value of overall margins changes frequently.
How to Avoid a Margin Call
A margin call occurs when the value of your assets goes below the amount you have borrowed from your broker, and your account funds diminish to a dangerously low level.
It’s important to avoid margin calls because they can lead to significant losses. If you don’t have enough money in your account to cover the margin call, you will be forced to sell assets at a loss and lose out on the opportunity for future profits.
If you want to avoid a margin call, there are several things you can do. First, make sure to fund your account regularly. This way, you can have sufficient collateral to cover any potential losses. Second, don’t take too many trading positions, as this can put additional pressure on your account. Third, use stop losses to protect yourself from potential losses on individual trades.
Fourth, manage position sizes carefully so that you can minimize risk while still taking advantage of opportunities in the market. Finally, don’t trade in too many markets at once – this will make it difficult for you to manage your portfolio effectively and could lead to disaster if one of those markets begins experiencing volatility.
The key takeaway from this article is that margin trading can be risky if you don’t have a firm handle on the market. Therefore, it’s important to make a wise choice to avoid potential losses and figure out ways to mitigate financial risks later.
Any loss you may incur due to margin trading will be charged from your account. If the value of your collateral goes down, so will the value of your margin trading balance.