Advantages of margin trading
In the article I am going to describe leverage and the advantages of trading with broker’s funds
What is leverage and what is margin for?
Five years ago, I started a career of taxi driver, driving my own car. Driving around the city can bring profits. At least, my friends said so. I received my driving license at the university, hoping to buy a car soon. But there wasn’t a need, and just driving around the city was quite expensive. Good potential income enabled me to take a loan from the bank, using the car, I bought, as a collateral to secure the loan. Of course, there was a risk to lose my purchase, in case of non-payment the bank could take the car. But I managed pay the debt earlier.
Most of you have the experience of getting a loan, so you know what it is about. Do you know that you can do same when trading commodities, shares and currencies on the exchange? You can trade using borrowed funds from a broker, with a certain margin as a security for the loan. For example, having $1000 on your account, you can initiate trades for an amount of 100 times and even 500 times more than your own funds. Isn’t it a good prospect to make more profits?
This way of increasing your trade volume manifold is called leverage, and the way of trading is margin trading. The amount, you want to exceed your own funds, depends on the leverage. That means, you don’t have to wait until you possess a large amount of money, necessary to start stock trading and make profits, you can use the funds borrowed from a broker to open positions. I did the same when I was buying my car. The risk in margin trading is slightly different from that in buying a car or an apartment on credit. Using leverage, you risk only your own money that is on your trading account, so-called margin. Brokers will automatically close all loss-making trades and won’t let you owe them money.
Financial leverage
For example, you deposited $1000 in your account and want to increase your potential gains, whose amount depends on the volume of trade and the price of a point. So, you choose leverage 1:100 and can initiate trades with total volume up to $100 000. But you shouldn’t forget about money management principles, which enable you to manage borrowed funds and get good returns, using leverage.
Leverage amount depends on the broker, account type and trading instrument. There are following ways to record it. For example, to buy shares for $5000, you need a margin of $1000 on your account. Then:
- 1:5 is the own funds/volume bought ratio;
- 1:4 is the own funds/borrowed funds, needed for the purchase ratio;
- 20% is an amount of own money in the volume of a position
Assessment of margin
Margin trading means that broker gives a loan on a collateral, called margin. During the time, when you have positions, opened with a leverage, this margin is “frozen”.
Let’s study the mechanism on a common example. For example, I bought shares for $5000, having a margin of $1000. The difference between the volume of the position and that of my own funds was lent by the broker. Now, I am the owner of share CFD for $5000. However, I am not the beneficial owner, as they form a collateral for the loan from the broker. A similar situation is when one takes a car secured loan or mortgage credit.
If the shares’ price goes up, then I’ll succeed. Any time I can sell them and make profits. Note that the profits will be much higher (the difference equals to the amount of leverage), than I could make with my own deposit of $1000. Broker receives a commission fee and gets back the funds lent.
If the shares’ price decreases, and I don’t close the loss-making position myself, then the broker will do that automatically, when the limit of margin requirements is approached, that is when the total cost drops down to $4000. Broker will lose nothing, he will only get the commission fee. I will lose my $1000.
Simply put, financial leverage is a kind of multiplier. The use of it multiplies both the potential risks and your potential gains. To use it correctly, one needs to know the rules of money management, be able to analyze the current situation on the stock exchange and consider the risks of the asset price to reverse in the direction, opposite to the predicted one. Besides, one should develop discipline. Just to know is not enough, it is necessary to follow the rules of behavior in the market, which have been worked out.
How to take a loan from a broker?
It is simple to trade commodities, currencies or shares on the stock exchange, exceeding the amount of own funds. Unlike bank loans, margin trading involves no red tape, no papers. Almost all brokers indicate the conditions of credit service provision in the offer agreement, which is submitted to all traders to examine, accept and sign.
You even don’t have to calculate the amount of leverage yourself. All the calculations are carried out automatically in the trading terminal.
Is it always necessary to use financial leverage?
I use all capacities of margin lending when open all of my positions. I also follow the rules of money management, calculate the amount, I can risk without a damage to my deposit, and, according to the trading account statistics, I have more profitable trades than loss-making ones. So, leverage, as a rule, works to my advantage. To choose the best way of trading, try both trading without leverage and using it when you initiate all of your positions.
Financial leverage and the danger of success
From time to time, a good fortune falls into traders’ hands. During such periods, one should be extremely careful. The market “gave” big money to many of those, who went bankrupt later. Of course, the market has nothing human. It is completely indifferent to whether you will gain or lose. Nevertheless, a chart confuses most traders.
How I gained and went bankrupt using leverage
That happened in December, 2008, when the U.S. Fed reduced the rate down to 0-0.25%. Everybody was waiting for the Fed to change the rate, and this moment came. EUR/USD chart started growing fast, the American currency was getting cheaper by the minute. At that time, many American shares started to grow in price. I entered the market with very large volume, and large amounts of money started emerging on my trading account. Of course, I enjoyed such trading. At the same time, I didn’t understand that I was getting addicted to gambling. That was gambling, not trading. When you trade at full capacity, increasing your trade volume all the time, you can be punished by the market. If I had had an exact plan, for example, to double or triple my deposit and then close all the positions, everything would have ended well. Unfortunately, I went bankrupt the next day. A moderate correction, that is inevitable, ruined my account.
Conclusion
In the stock market, brokers offer a less leverage, shares move more directly than currency pairs or commodities, so, it is less dangerous to use leverage there. In the exchange market, brokers offer large leverage, but that involves not only big opportunities and potential gains but potential losses as well.
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