avatarEsteban Thilliez

Summarize

Margin Trading Explained

With some Examples

Margin trading is an important subject, but one that is rarely completely understood. A lot of traders trading on margin don’t understand how it works and end up blowing their accounts.

Today I’ll try to explain how margin trading works, in a few words, and with some examples.

What is Margin Trading

Margin trading is a way to trade with money you don’t own. It allows you to borrow money from your broker.

This way, you can earn a lot of money with a small account. But it works on the other side too, you can lose a lot of money. And I’ll discuss it later, but margin trading is not a magic way to x100 your profits.

You probably already have heard about “leverage”. It’s related to margin trading. It represents what you can trade with, depending on what is your collateral. Let’s say you’re trading with an x100 leverage, you just have to use 1$ to trade with 100$.

How Margin Trading Works

Margin trading requires you to deposit money as collateral. This collateral is called “margin”. It’s like an assurance that you can hold the trade. It’s not a cost. That means you get your collateral back when the trade is closed.

Let’s say you want to buy $100 000 worth of EUR/USD. You don’t have $100 000 to spend, so you’ll trade on margin. Depending on your broker, the minimum collateral can be $1 000, $5 000, $10 000, etc… In this example, it’s $1 000. It’s called the margin requirement. Here, it represents 1%.

You open this position using $1 000 as collateral.

The used margin is the sum of the required margins of all your positions. In this example, you have only one position opened, so the used margin is equal to the margin and is $1 000.

The equity is the current value of your account. It’s your account balance + your floating profits or losses. Here it’s $5 000. Now, the price goes up by $50. Your equity will be $5 050 as you have a $5 000 account balance and a $50 unrealized profit.

The free margin is the difference between equity and used margin. Here it’s $5 050 — $1 000 = $4 050.

Now, I’ll introduce an important notion: the margin level. It’s the percentage value of equity versus the used margin. Here it’s $5 050 / $1 000 * 100 = 505%.

The lower the margin level, the worse it is for you. It’s because a bad thing may happen: a margin call.

Depending on your brokers, you should always keep your margin level above a certain percentage. For most of the brokers, it’s 100%, but it depends. When your margin level is below this threshold, you receive a margin call. It’s a warning to say your positions may be liquidated.

Let’s get back to our example. Our $50 profit turned into a $4 000 loss. Our equity is $5 000 — $4 000 = $1 000. The used margin remains the same because we have not opened any other trade. Now, our margin level is $1 000 / $1 000 * 100 = 100%. We receive a margin call.

But our loss continues, and we now have a $4 500 loss. Our margin level is now 50%, and our position gets closed by our broker because it’s below the stop-out level. The stop-out level is a minimum margin level defined by your broker. If your margin level falls below this threshold, your positions will be liquidated until you get back above this level.

If for example, you have 3 trades opened, and closing one allows you to get back above the 50% margin level, only this one will be closed.

In our example, we have just one position opened, so it’s the only one closed. It means in the example, we lost $4 500 and our account balance is now $500.

I hope you’ve understood the example, it explains most of the margin trading concepts.

The Correct Way to Trade on Margin

Margin trading is very attractive for all new traders, but as the example shows, it can be dangerous. It’s a powerful tool, for the best and worse.

Before trading on margin, you have to set specific risk management rules. Let’s say for the example you don’t want to risk more than 1% of your account for each trade.

For example, we’ll imagine you want to buy a fictive asset called “X”. Let’s say X’s price is currently $20 000. You have a $1 000 balance. You think X’s price will increase soon, so you’ll buy X. You also think X’s price can’t go lower than $19 900.

So you will buy X at $20 000 with a stop loss at $19 900. With your current balance, you can buy 0.05 X without margin. If your stop loss gets hit, you lose $5, or 0.5% of your account. But according to your risk management rules, you can risk up to 1% of your account for each trade.

So instead of buying 0.05 X, you can buy 0.1 X on margin. This way your risk will be 1%. Let’s say the margin requirement is 10%. You have to spend $200 as collateral to open a $2 000 worth position.

By doing this, you still have $800 free margin, so you can, for example, open another $2 000 position using $200 to buy a fictive Y asset, and spread your exposure over many assets, while sticking to your risk management rules.

To summarize, you have to see margin trading and leverage as tools to stick to your risk management rules, not as a magic way to x100 your profits, else you’ll blow your account faster than light.

The Fees

I’ve not talked about the fees in the examples, but when trading on margin, you have to pay the same fees as if you were not. Your broker doesn’t care whether you’re trading with its money or yours, you have to pay!

For example, if the fees are 0.1% of the position when opening a position, and you decide to buy $100 000 worth of X with a $1 000 account, you have to pay $100 in fees.

As soon as your trade is opened you already have lost $100, or 10% of your account.

The best case would be if you had the $100 000 in your account because the $100 fees would be negligible, representing only 0.1% of your account. But because you don’t have, you have to calculate the fees before opening a position with leverage, and eventually take them into account to place your stop loss.

That’s why fees are important, and the less leverage you use, the better!

Also, as you’re taking a loan, you have interests to pay. These interests are negligible for small durations, but if you keep your broker’s money for days or months, you have to take them into account.

Final Note

A lot of brokers offer big leverages: x100, x500, x1000. Many new traders see this as a way to quickly grow their account, but it’s just a way to blow them faster.

As conclusion, the most important thing is to always stick to your risk management rules, especially when trading on margin.

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