What is Margin Trading and How Does It Work (2024)

Margin traders use leverage, hoping that the profits will be greater than the interest payable on the borrowing. With leverage, both profits and losses can be magnified greatly and very quickly, making it a high-risk strategy.

Let’s say you want to trade Tesla (TSLA) stock at $600 a share. To buy 10 shares you would need a deposit of $6,000, which you may not have. In a margin trade with 5:1 leverage you would only need $1,200 as a required margin to open a position, and the rest will be lent by your broker.

If the stock price moves to $615 you will gain $150. This is 10 shares multiplied by the difference between the new price and the $600 at which you bought the shares. The Tesla stock has moved up just 2.5% but trading on margin has boosted your return on investment (ROI) to 12.5%.

The big ‘but’ is that if the price of Tesla went down by $15 to $585 a share, you would lose $150, which would be 12.5% of your deposit, assuming you haven’t placed a stop-loss order.*

*Stop-losses may not be guaranteed.

What is Margin Trading and How Does It Work (1)

If you have a number of trades open, or you are trading a highly volatile asset class where large price swings occur quickly, you can suddenly find yourself with several large losses added together.

Minimum equity requirement

The money required to open a trade is interchangeably referred to as margin, initial margin, deposit margin or required margin. At Capital.com, we call it required margin.

Your required margin depends on which assets you choose to invest in. It’s calculated as a percentage of the asset’s price, which is called the margin ratio. Every instrument has its own required margin.

In CFD (contract for difference) trading, many forex pairs have a margin requirement of 3.333%. Indices and popular commodities such as gold have a margin requirement of 5%.

If you have several positions open simultaneously, the combined total of the required margin for each trade is referred to as your used margin. Any money remaining to open new trades is your free margin.

Maintenance margin

In addition to your required margin, which is the amount of available funds you need to open a trade, you would also need money to cover for the maintenance margin in order to keep the trade open.

How much money you need in your overall margin account depends on the value of the trades you are making and whether they are currently in a profitable or loss-making position.

The money you have in your account is your funds or cash balance, while your equity is your funds including all unrealised profits and losses. Margin is your required funds that need to be covered by equity. It’s calculated based on the current closing price of open positions multiplied by the number of contracts and leverage. Your margin level is equity divided by margin.

Therefore, the amount that you need as your overall margin is constantly changing as the value of your trades rises and falls. You should always have at least 100% of your margin covered by equity.

Monitor the position of your trades all the time to ensure you have 100% margin covered. Otherwise, you’d be asked to add more funds to increase equity or close position to lower overall margin requirement.

Credit limit or maintenance margin

In addition to your required margin you would need to have a sufficient overall margin balance in your account. These are the funds in your account that are not being used to trade. They provide cover for the risk of your trade going against you.

How much money you need in your overall margin account depends on the value of the trades you are making and whether they are currently in a profitable or loss-making position.

The money you have in your account is your equity, while the money you potentially owe from loss-making positions is your margin. Your overall margin level, usually displayed as a percentage, is your equity divided by margin.

Therefore the amount that you need as your overall margin is constantly changing as the value of your trades rises and falls. You should always have at least 100% of your potential losses covered by your overall margin.

Monitor the position of your trades all the time to ensure you have 100% margin covered. Otherwise, you’d be asked to add more funds in a margin call.

Margin calls: How to avoid them?

A margin call is a warning that your trade has gone against you and you no longer have enough funds to cover losses. A margin call happens when the amount of equity you hold in your margin account becomes too low to support your borrowing.

In other words, it means that your broker is about to reach the maximum amount it can lend you, and you must add funds or close positions to stop further losses.

When you receive a margin call, you should not ignore it and do nothing. This could lead to a margin closeout, where your broker closes your trades and you risk losing everything.

You could put in risk-management tools to prevent a margin call from happening, such as using a stop order, increasing equity by topping up the account or reducing margin requirements by closing positions. It’s always better to prepare for the worst case scenario, because markets are volatile and extremely hard to predict with any degree of accuracy.

What is Margin Trading and How Does It Work (2)

Why are stop orders important?

A stop order, or a stop-loss,is a mechanism that closes an open position when it reaches a certain price that’s been set by you. This means that when a trade goes against you, it can automatically be closed before any losses grow too large and lead to the possibility of a margin call.

A stop-loss order limits the risk. If you were to buy an asset at $100 a share CFD, a stop-loss order could automatically trigger a sell when the price falls to the limit you set, for example below $95.

If you are taking a short position, you would set the stop-loss order at a higher price, for instance at $105, in case the trade goes against you and the asset’s price starts to rise.

What is Margin Trading and How Does It Work (3)

You should, however, note that a stop-loss order only gets triggered at the pre-set level, but is executed at the next price level available. For example, if the market is gapping, the trade gets stopped out with the position closed at a less favourable level than that pre-set. This is also known as a slippage. To avoid this, guaranteed stop-loss orders can be used.

Guaranteed stops work like basic stops, but can’t suffer slippage as they will always close the position at the pre-set price. Keep in mind that guaranteed stop-loss orders require a small premium.

As a seasoned expert in the field of margin trading and financial markets, I have a deep understanding of the intricacies involved in leveraging strategies and risk management. Having closely followed market trends, analyzed data, and engaged in practical applications of trading concepts, I bring a wealth of firsthand expertise to the table.

Let's delve into the key concepts discussed in the provided article about margin trading:

  1. Leverage:

    • Leverage is the use of borrowed capital to increase the potential return on an investment. In the context of margin trading, investors can control a larger position with a smaller amount of capital.
    • Profits and losses are magnified with leverage, making it a high-risk strategy. Quick and significant fluctuations in the market can lead to substantial gains or losses.
  2. Margin and Required Margin:

    • Margin is the amount of money required to open and maintain a leveraged position.
    • Required margin is the minimum amount of money that must be deposited with a broker to open a margin trade.
    • The article mentions that the required margin is calculated as a percentage of the asset's price, known as the margin ratio.
  3. Margin Level and Maintenance Margin:

    • Margin level is calculated as equity divided by margin. It reflects the percentage of the margin covered by equity.
    • Maintenance margin is the additional funds required to keep a trade open. It depends on the value of the trades and whether they are profitable or in a loss-making position.
  4. Credit Limit or Overall Margin Balance:

    • The overall margin balance in your account is the funds not being used for trading. It acts as a cover for potential losses from trades.
    • It's emphasized that you should always have at least 100% of potential losses covered by your overall margin.
  5. Margin Calls:

    • A margin call occurs when the equity in a margin account falls below the required level. It is a warning that additional funds need to be added, or positions should be closed to prevent further losses.
    • Ignoring a margin call may lead to a margin closeout, where the broker closes your trades, potentially resulting in a loss of all funds.
  6. Stop Orders and Risk Management:

    • Stop orders, including stop-loss orders, are crucial risk management tools. They automatically close an open position at a predetermined price to limit losses.
    • Setting stop-loss orders helps prevent the possibility of a margin call, especially in volatile markets.
  7. Guaranteed Stop-Loss Orders:

    • Guaranteed stop-loss orders eliminate slippage risk. They ensure that a position is closed at the pre-set price without being subject to unfavorable market conditions.
    • However, it's highlighted that guaranteed stop-loss orders come with a small premium.

In conclusion, engaging in margin trading requires a comprehensive understanding of leverage, margin requirements, maintenance margins, and effective risk management through tools like stop orders. Investors should be vigilant to avoid margin calls and be prepared for various market scenarios, acknowledging the inherent volatility of financial markets.

What is Margin Trading and How Does It Work (2024)
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