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Margin trading - definition, benefits and risks

What is margin trading and what are its risks

Seven months after starting a brokerage account, Wilson was able to make a decent profit. He's only bought the shares with his own money so far, but a friend pressures him to try leveraged trades instead, which could mean using the broker's money as collateral. This is what they call margin trading, and it is claimed to have a much higher potential for profit. But is margin trading suitable for a novice investor, is it worthwhile to start such tests, and what can they produce?

Margin trading  definition, benefits and risks

What is margin trading?

The investor is not limited to using his assets to transact in the stock exchange. Brokers and forex traders sometimes offer to lend clients money and assets to trade on the exchange for a pre-determined percentage. They will not be added to the account, so the owner will not be able to withdraw funds from it, but will be able to use it for transactions.

As collateral, the investor's assets ensure that he will be able to compensate his broker. Margin is a term for such a deposit, while leverage is a measure of how much the transaction amount increases. As a result, operations in which a client uses the assets of a forex broker or trader are often referred to as margin trading or leveraged trading. In addition, margin transactions themselves are not guaranteed.

The leverage will greatly enhance the value of the trade if you make a profit. However, losses will also rise proportionately in case of failure.

For $100.00, Wilson bought shares of Superbank. The value of these securities increased by 2% over the course of the day. Wilson earned $2.00 from his sale. His total income would be $10.00 if he took out a $400.00 intermediary loan and used it to purchase Superbank documents. He would not lose $2.00 but $10.00 if the stock price fell by the same 2%.

Traders who engage in margin trading have the opportunity to benefit from rising and falling asset prices. Suppose an investor expects a decrease in the value of some of his shares. He sells it first and then buys it again at a lower price, getting the difference as profit.

Trades are referred to as "long" if the market is in an uptrend and "short" if the market is in a downtrend.

By borrowing assets from a broker and selling them, margin trading allows you to profit from asset sales even outside the portfolio. If the price of these documents drops, you can buy them later at a lower price and return them to the broker, keeping the price difference. However, if the price goes up, you will incur losses in exchange for gains; You will still need to return the assets to the broker, but you will have to pay more for them.

Wilson is sure that TaxebeBank's stock price will drop significantly soon. Lacking these securities, he borrows 1,00 shares from a broker for 35 shares and sells them, making $350.00. Three days later, the price of the paper has effectively fallen to $30 per share. Wilson spends $300.00 to buy 1,00 shares of TaxebeBank and sell them back to the broker. Therefore, Wilson stayed at $50.00. A commission for transactions and a percentage for the use of borrowed assets, totaling about $70, must be paid to the broker.

Wilson would have had to pay $380.00 per share and would have also lost $30.00 in transaction and $70 in commission and interest if the share price had risen to $38, contrary to his estimates.

Please note that not all instruments are eligible for margin trading. Brokers provide a list of assets that can be bought or sold using leverage on their website or in the terminal.

A reverse trade is always considered part of a "short" margin trade. If you sell assets that you borrowed from a broker, or if you open a position, you must eventually buy the securities and return them, or you must close the position.

You are not required to sell leveraged securities that you buy as part of a "long" position after buying a certain number of them. To return your money to the broker, simply fund your account.

What are the factors that determine the effect?

When considering funds or securities offered on credit, leverage is the ratio of the investor's assets to the value of the transaction.

Wilson can buy the stock for $100.00. The broker agrees to lend him an additional $400 for the total transaction price of $500. The leverage in this case will be 1:5.

Three factors determine how much cash or securities the broker will lend.

The first factor

Clearing institutions set the minimum risk or discount rate for each financial instrument each day. Brokers are allowed to apply additional discounts to the shares of their clients, but these discounts cannot be less than the minimum on the exchange.

The clearing organization considers the following factors when determining the discount:

The liquidity of the security, or the speed with which it can be sold for a profit,

Volatility is the ability of the price to change quickly and significantly.

The prices are unpredictable, the discount is bigger, and the leverage is lower for this tool, the more difficult it is to find a buyer. The broker divides the amount of the client's own funds by the discount to determine the maximum allowable size of a leveraged transaction.

On Superbank shares, the OCC sets a discount of 0.20. If Wilson has $100,000 in his account, he can use the margin loan to purchase up to 1,000.00/0.2 = $5,000.00 shares. This means that the maximum leverage for the instrument is 1:5.

However, the discounts for the majority of instruments will be higher than the minimum and the leverage will be less than the maximum for many investors. The degree of risk attributed to an individual is a different indicator.

2. The investor's level of risk

The investor's level of risk

The mediator makes the decision. The client is automatically given a standard or initial risk level when opening an account by default.

An investor who maintains at least $300,000 in cash or securities in a brokerage account is exposed to an increased level of risk. Or when all three conditions are met at once:

The investment account was opened more than 180 days ago, and trades were made in at least five of those 180 days. His total assets in the account are over $600.00.

The discount set by the Financial Instruments Clearing Agency is applied to risk-averse investors. In addition, the broker will create a higher discount for each financial instrument for less affluent and unskilled clients.

Wilson has been trading regularly for over six months, but his account balance is barely $100. Therefore, it represents a historically high risk for investors. He wants to buy shares of Superbank, to which the OCC assigned a discount of 0.2, but the broker set the price of Wilson at 0.4. Thus, the transaction amount is limited to $100.00 / 0.4 = $250.00. So, the largest leverage will be 1:2.5.

You can view discounts for each security amount and available transaction amounts in your personal account on the broker's website or in your trading terminal. These discounts already represent the investor's level of risk.

Before each of the client's leverage transactions, the broker calculates this indicator on his behalf. Margin is the value of the assets in the investor's account after deducting the discount that is still owed to the broker on those assets. only those instruments that are easy to sell and have the highest liquidity are aggregated; Each broker publishes their list on their website.

Wilson paid $100.00 for the shares and added another $100.00 to the brokerage account. Margin is calculated at a discount of 0.5 and includes shares purchased. As a result, the broker rates them using a coefficient of 0.5 instead of the current market value. In other words, the margin was 100.00 (the amount in the account) plus 50.00 (the inventory value, taking into account the discount) = $150.00.

Margin changes in response to changes in profit or loss. However, the broker usually guarantees that the margin is not less than the minimum, which ensures that the client is able to repay the loan.

The broker uses the following formula to calculate the maximum margin loan amount: the margin is divided by the instrument's deduction, and then the investor's own money is removed from the result.

Wilson is interested in buying shares of Superbank, which has a discount of 0.4. Wilson has $100.00 on its balance sheet, but the broker calculated the margin to be $150.00 after taking other securities into account. This suggests that the maximum he can spend on Superbank shares is $150,00/0.4, or $375.00. Of these, the broker will invest $100.00 and borrow $275.00, each from another party.

In fact, there is no need to go into the details of margin and debit-based accounts for leverage and credit. You can see exactly how many securities are selected and how much you can buy in margin trading mode when choosing an instrument in the broker's terminal.

Even if you are just starting to trade, it is not required to use as much leverage. Leverage, after all, doubles your gains and losses by twice as much. For example, if you use all your money to make a trade with 1:10 leverage and the prices move 10% against you, you will lose all the money in your account.

Even if you are just beginning to trade, it is not required to employ the highest amount of leverage. Leverage, after all, multiplies your gains and losses by a factor of two. For instance, if you use all of your funds to make a deal with a leverage of 1:10 and prices move by 10% against you, you will lose all of the money in your account.

Other regulations, such as legal restrictions, govern the maximum leverage allowed in the FX market. A qualified investor may receive leverage from a currency dealer of up to 1:50. This ratio is lower for customers lacking the "quala" designation; the dealer determines it every day using data on currency swings over the past 365 days. Leverage occurs most frequently between 1:15 and 1:35. This shields novice investors from significant losses, at least in part.

When this occurs, the broker typically informs the client that he must fill his account in order to close the trade, as the value of the assets may not be sufficient. A margin call occurs when such a message arrives via email or the trading terminal.

The amount of losses at which brokers issue a margin call is up to them. Some promptly inform the client whenever the margin shrinks by at least one ruble. Others notify the investor when their own assets, such as stocks, lose, say, 50% or even 80% of their value. Others choose not to utilize a margin call at all, which puts them at much greater danger because they could suddenly lose all of their assets.

The broker typically applies a stop out, which means that it will forcibly liquidate positions in order to restore the investor's money, if the investor does not deposit money into the account and the losses reach a specific level (typically between 50 and 90 percent of the margin). The client will suffer losses in this scenario.

In anticipation of their growth, Wilson borrowed 375,00 dollars to purchase shares of Superbank at a leverage of 1:2.5. He had a profit of 150,00 dollar. But after a few days, the price of the bank's shares started to drop quickly. Wilson failed to receive the margin call provided by the broker. The broker personally sold all of the Superbank shares that were on Wilson's account when the stock price dropped by 20%. Half of his margin, or 75,00 dollars, had been lost by this point.

Brokers always state in trading programs the minimal margin amount of the client at which they will close his positions. But bear in mind that while brokers are free to utilize stop outs, they are not compelled to do so. Losses could exceed the margin, leaving you owing money to the broker. Because of this, you shouldn't solely rely on margin calls and stop outs; instead, you should independently check on the health of your portfolio.

What is the price of a margin loan?

When you use borrowed money inside the same trading day, there are often no fees associated with the borrowing. However, if you keep the broker's funds or securities for a longer period of time, he will deduct interest on the use of his resources. Rates typically fall between 15 and 20 percent every year, or 0.04 percent to 0.05 percent per day. Furthermore, you will always be required to pay a commission for transactions.

The commission paid by Wilson's broker is 0.05 percent for each security buy and sell, as well as 0.04 percent per day of the amount of money or asset worth lent. WILSON was required to pay 67 dollar for a margin trade involving Superbank shares: 375,00 0.05 percent (for the acquisition of stocks) + 300,00 0.05 percent (for the selling) + 275,00 0.04 percent x 3 days (for a loan). Additionally, the transaction itself cost him 75,00 dollar.

Even on exchange non-working days, brokers levy a daily margin borrowing cost. The credit rate can bring all earnings to naught if you hold trades open for an extended period of time. Because of this, leveraged deals are typically completed within a short period of time.

Do beginning investors have access to leveraged deals?

What is margin trading and what are its risks

High risks are involved in margin trading. As a result, novice investors must be tested before beginning to trade with leverage. The broker will offer you to pass the test as soon as you wish to conduct the first margin deal. It's unpaid.

Your knowledge will be evaluated via questions. You must define margin trading correctly, say whether the broker has the right to charge you for a margin loan, and calculate the potential losses. You must be aware of the circumstances under which the broker may compel a client's position to be closed.

As many times as you'd like, you can retake the exam. However, even if you are unable to provide accurate answers to all of the questions, the broker may still permit you to conduct unsecured transactions up to 100,00 dollar while cautioning you about the risks.

It is more challenging to test for margin trading access in the currency market. Compared to the Leveraged Stock Market test, it has more questions. You won't be able to place any transactions unless you provide accurate answers because the risks associated with trading forex are very significant.

The book "Where to Learn to Invest" contains information on how to study for exams and how to get started learning.

I aced the exam. How can I apply for a margin loan?

Since the potential of margin loan is already described in the brokerage agreement, you typically do not need to create any additional paperwork.

It is sufficient to switch on the margin trading mode in the trading terminal in order to use the broker's funds for transactions. But it is crucial to exercise considerable caution because transactions involving leverage are straightforward. It is possible to unintentionally purchase securities for more money than you have or even sell shares you do not own before realizing that all of the transactions were made using borrowed money.

In order to decrease the likelihood of mistakes and losses, it is preferable to leave the margin trading mode off and only activate it when absolutely necessary.

Why is it necessary when there are so many risks associated with margin trading? Could it be of use?

You must be an experienced trader to use margin trading to profit from changes in the value of securities. However, there are times when using leverage in a transaction has fewer risks and can be beneficial for even inexperienced investors.

Prior to moving funds from your bank to your brokerage account, make a purchase.

Wilson has Superbank stock; he earns respectable dividends from it and would purchase more if they were less expensive. The cost of the paper suddenly dropped to the level Wilson had just dreamed of. He has a tiny sum in the brokerage account, so you need to move immediately. A day or two will pass as he transfers the funds from the bank, and everything could alter once more in that time. Additionally, using leverage allows you to purchase securities right now and then patiently wait for the account to be refilled.

Cash gap

Aleksey made the decision to exchange his Superbank stock for TaxebeBank bonds, whose price is currently quite beneficial. Wilson is concerned that bonds will increase in value during this time since, in accordance with the exchange's rules, the proceeds from the sale of shares will not be deposited to the account for two days following the transaction. He can make an investment in Taxebe Bank right away with the aid of a margin loan. As soon as the funds for the shares are deposited into the account, Wilson will pay a tiny percentage as compensation for using the leverage and pay back the broker.

Buy before sell

Aleksey purchased TaxebeBank bonds. However, he is now considering exchanging them for shares in Acceptable Bank that, in his opinion, are more promising. Currently, Acceptable Bank documents cost 12 dollars each, but Wilson wants to purchase them for just 10. He might have offered $10 for the shares of Acceptable Bank after selling his TaxebeBank bonds. When the cost of the securities he requires will drop to this level is not known, though. Wilson might have to retain a sizable sum of money in the account for an extended period of time without receiving any income.

Aleksey can hold TaxebeBank bonds instead, earn income on them, and then sit back and wait for the price of Primlemo-shares Bank's to decline. When this occurs, acquire additional securities using a margin loan right away, then sell surplus bonds to settle the obligation. His broker won't charge him for the loan if both trades close on the same trading day.

However, you should carefully consider your benefits before engaging in any leveraged transactions. For example, can taking out a margin loan allow you to save money considering that the broker will charge interest?

If I still intend to trade using leverage, how can I lower my risks?

Trading on margin carries a higher level of risk than dealing with your own funds, but you can lower the dangers.

Ensure that you are in control of your positions in the trading terminal to prevent unintentional shoulder contact.

Use stop loss (stop loss) to automatically exit the transaction when certain criteria are met, which you specify. For instance, a position could be liquidated as soon as the cost of an asset or the maximum you set on your loss is reached. So at least don't be frightened to incur losses that are more than what is permitted. Typically, the trading terminal is where the stop loss option is set up.

A stop loss, however, might not be effective, for instance, if no one wants to buy or sell shares at the price you require in the market. In this situation, the broker is not liable if your order is not filled.

Even if the broker employs a margin call and a stop out, you should always monitor the margin level on trades. Restock your account if necessary, or stop trading. If not, you risk losing all of your assets in addition to continuing to owe the broker money.

Avoid using leveraged money to the fullest extent possible if you choose to engage in margin trading. Keep in mind that leverage has the power to wipe out your account by turning even a tiny wave in the market into a tsunami.