Understanding Margin and Margin Trading

Margin trading has been around since the early 20th century. While it has always been a high-risk trading strategy, it wasn't highly regulated until after the 1929 stock market crash.

Regulations vary between countries and markets, but they typically influence minimum initial investment amounts, maximum leverage rates, and borrowing limits on margin trading accounts.

However, increased regulation and stricter requirements are meant primarily to protect markets and economies. While margin trading is now more structured and accessible, it remains a strategy that requires deep understanding and careful risk management.

What Is Buying on Margin?

Buying on margin—or margin trading—is the practice of borrowing funds from a broker to purchase securities, such as stocks or other financial assets. Margin traders use a portion of their own funds—the margin—along with the borrowed funds to buy more financial assets than they could normally afford. Margin trading is common in both forex and stock markets because buying securities on margin increases buying power. The value of the purchased assets and cash in the account are held as collateral for the loan.

How Buying on Margin Works

To buy on margin, a margin trading account must be opened with a broker. Unlike a regular cash account, a margin account allows a trader to borrow money from the broker to buy stocks. Using a combination of risk management policies and regulatory requirements, the broker sets minimum margin requirements – the amount of personal funds that need to be deposited into the margin trading account.

Margin Trading and Leverage

Leverage is a key feature of margin trading and refers to the ability for a trader to control a larger position using a small amount of personal capital. Leverage is expressed as a ratio, such as 30:1, 20:1, or 2:1. When used effectively, leverage can significantly increase returns compared to trading with only personal funds. However, if the market moves unfavourably, leverage can also worsen potential losses. This increased risk emphasises the need for careful strategy and effective risk management in margin trading.

To illustrate, a trader wants to buy a currency pair valued at $300,000. Without leverage, the trader would need $300,000 to make the trade. When buying on margin, if the broker offers a leverage ratio of 30:1, the trader will only need to deposit $10,000 as margin – 3.33% of the total trade value.

Loan Repayment and Interest

Like any loan, the funds borrowed to buy on margin must be repaid, and interest accrues on the borrowed funds. Interest rates on margin loans vary depending on the broker and prevailing market conditions, and these costs can add up if positions are held for an extended period. Factoring in interest costs when calculating potential returns is essential, as they will impact overall profitability.

Types of Margin

There are two types of margin commonly referred to in trades:

• Initial Margin: The amount of personal capital a broker requires to open a margin position. It is typically a percentage of the total trade value, and the percentage varies between brokers.
• Maintenance Margin: The minimum margin balance—or amount of equity—that must be maintained to keep a margin position open. If the account balance falls below this level due to market movements, a margin call may be issued.

Terms like free margin and used margin refer to the state of equity in margin trading accounts. Margin that is allocated to open positions is used margin and it cannot be used for other trades until the positions are closed. Free margin is equity in a margin account that is not currently used for open positions. Monitoring these balances is essential for managing margin levels and avoiding margin calls.

What Are the Risks of Trading on Margin?

The appeal of margin trading lies in the ability for traders to increase their position size without committing a large amount of personal capital. However, the same leverage that can potentially increase gains can also amplify losses. Assessing risk tolerance is essential when it comes to buying on margin, along with awareness of several specific risks.

Bigger Losses

Along with the potential to increase returns, margin trading can also lead to larger losses. For example, with 50:1 leverage, a trader could control $50,000 worth of currency with only $1,000 in a margin account. If the currency declines by 3%, the trader will have lost all of their own capital and will owe the broker $500, plus interest and commission.

Margin Calls

A margin call occurs when the equity in a margin account falls below the broker's maintenance margin requirements. With a margin call, a trader is given notice to immediately top up the funds on their account or liquidate assets.

Forced Liquidation

If a trader misses the margin call deadline, the broker may liquidate assets to bring the margin balance back to the required level. Trader approval is not needed with a forced liquidation, and the broker will choose which open positions to close at whatever the current price is.

Market Volatility

Markets are highly volatile, and price movements can't be predicted with any degree of accuracy. Significant market shifts increase the likelihood of margin calls and forced liquidation, and margin traders need to be prepared for this.

Interest Costs

Interest accumulates for each day positions are held, even on trades resulting in a loss. If linked to market rates, interest costs can increase with little-to-no warning.

Many of these risks can be mitigated with a good risk management strategy. Aside from a thorough understanding of margins and margin trading, setting stop-loss orders and diversifying investments can also minimise risk exposure.

Advantages of Margin Trading

Naturally, any activity that involves considerable risk also offers appealing advantages, with the chance of maximising returns being the most notable with margin trading.

Bigger Buying Power

Margin trading allows traders to control a much larger position than might be possible using personal funds alone. By borrowing funds from a broker, traders can purchase more assets, potentially resulting in higher profits when the market moves favourably. For instance, with 10:1 leverage, a personal investment of $1,000 can control $10,000 worth of assets.

Greater Returns

Although returns are heavily dependent on market performance, the leverage provided by margin trading can lead to greater profits. In low-volatility markets, where leveraging positions allows for capitalisation on minor fluctuations in stock prices, even small movements can result in substantial gains.

Portfolio Diversification

The greater buying power provided by margin trading makes it possible to invest in multiple positions instead of concentrating funds in a single asset. While it doesn't eliminate the risks of buying on margin, it can mitigate them further by reducing exposure to one asset or market.

Flexibility and Liquidity

Traders can usually only withdraw cash three days after selling any assets. With margin trading accounts, traders can withdraw the cash immediately, essentially borrowing the funds while waiting for the trade to clear. This also allows margin traders to open new positions faster. Aside from margin calls, brokers are usually flexible with repayment terms for any borrowed funds.

It is vital that traders always balance the benefits against the risks associated with buying on margin.

Is Margin Trading Good for Beginners?

The complexity and high level of risk involved in margin training may be challenging for beginners. It would likely be better to first build experience trading without margin, i.e., only using personal capital. Alternatively, some trading platforms offer demo accounts, allowing traders to practise trading on margin first, before progressing to live trading. Demo accounts also allow new and experienced traders to try new strategies with less risk exposure. Both approaches can help novice traders gain an understanding of trading basics and market dynamics and become confident in managing market volatility. Beginner traders should also develop a deep understanding of concepts like leverage and margin calls.

Starting with a conservative strategy—using lower leverage and setting strict stop-loss orders—can help manage risks during the learning process. Traders should be prepared for mistakes and losses, both of which can serve as valuable lessons that contribute to improved trading strategies in time. It can also be beneficial for beginner traders to get advice from experienced margin traders and financial advisors, especially concerning the risks involved.

Limiting Losses With Stop-Loss Orders

Stop-loss orders are a very effective mechanism for limiting losses in margin trading. Traders use stop-loss orders to automatically close an open position when asset prices fall to a limit set by the trader.

For example, a trader buys 10,000 units of the EUR/USD currency pair at an exchange rate of 1.2000 USD. The trader wants to limit losses to a 2% decrease in the value of the base currency and sets a stop-loss order at an exchange rate of 1.1760 USD. The trader can hold the position—or manually trade the currency pair—as long as the exchange rate doesn’t drop below 1.1761 USD.

Difference Between Margin Trading and Buying Stocks

Both buying stocks and margin trading involve investing; the difference between the two is in the approach and risk. Buying stocks outright using personal funds results in ownership of the shares. There is still risk involved, but it is limited to the amount of personal capital invested. Margin trading is using borrowed funds along with personal funds to increase buying power, with the potential for higher returns. However, the risk is far greater, since it involves both personal and borrowed funds. The borrowed funds still need to be repaid even if the market moves unfavourably and asset prices drop, resulting in losses. Which approach is followed depends on a trader’s goals, experience, and risk tolerance.

Short Selling

Short selling is a strategy that can be used with margin trading, typically when a decline in the purchase price is expected. Short selling involves borrowing stock from a broker and selling them at the current share price. If the price drops, the shares are bought back at the lower price and returned to the broker, with the difference—minus interest charges—pocketed as profit. While buying on margin typically anticipates rising prices, short selling focuses on declining asset prices.

The risk of loss remains high with this strategy, since the purchase price may rise instead of dropping, forcing the trader to buy the borrowed stock back at a much higher share price. Stop-loss orders can be used to minimise potential losses when short selling. However, the order is triggered when the purchase price increases to a set limit rather than decreasing.

While margin trading can be a powerful tool for experienced traders, beginners should approach it with caution and a thorough understanding of the potential downsides. Success in margin trading often depends on disciplined risk management, such as setting stop-loss orders, closely monitoring margin levels, and maintaining sufficient capital reserves.