Monday, January 18, 2016

Fundamentals of Trading: Margin Trading

You probably know by now that trading is a very risky business. But, do you know what’s even more risky than trading? It is called trading on a margin.

First of all, let me explain to you what “margin” is. Margin is a loan that is provided to you by your broker so you would be able to enter larger trades using a smaller amount of funds. With the help of the margin, you would be able to leverage your funds, allowing you to purchase stocks bigger than your current investment.

To be able to use margin, you need to open and be approved for a margin account first. The borrowed money is collateralized by the securities and cash in your margin account. The money that is being loaned to you doesn’t come free, however; it has to be paid back with interest.

Now, you might wonder how does margin and leverage works. It’s pretty simple. It works by multiplying your investment based on the leverage offered by your broker. Say for example, your broker offers a leverage ratio of 2:1. Due to the anticipation that Microsoft’s shares would rise, you’re tempted to buy shares of the stock, which is worth $100 per share. Unfortunately, you only have $1,000 in your trading account, which means you could only buy 10 shares of Microsoft. Fortunately, with the help of leverage of 2:1, you were able to buy $2,000 worth of shares, or equivalent to 20 shares.

Say the Microsoft’s share price surges 50% higher. Your investment will now be worth $3,000 ($2,000 + ($2,000 x 0.5)). After the broker is paid with the $1,000 you borrowed, you’ll have $2,000 left in your account, showing a total profit of $1,000. The stock price has only increased by 50%, but with the help of the leverage, you were able to generate a 100% return on investment. See how powerful leverage is?

However, you should still be careful when using margin to leverage your investments. Yes, trading on a margin can significantly raise your potential earnings, but it can also dramatically increase your losses.

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