Margin TradingMargin is basically an act of extending credit for the purposes of trading. For example, if you are trading on a 50 to 1 margin, then for every $1 in your account, you are able to trade $50 in a trade. This has both its drawbacks and advantages.
Advantage of Margin TradingWhy use margin? It gives increased buying power with less money. The advantage of trading on margin is that you can make a high percentage of gains compared to your account balance.Just as corporates borrow money from Public to invest in plants and machinery to increase their production capabilty thereby increasing their profit margins, investors can borrow money and leverage the cash they invest. If you pick the right investment, margin can dramatically increase your profit. The advantage of trading on margin is that you can make a high percentage of gains compared to your account balance. For instance, let?s assume that you have a $1000 account balance and you are not trading on margin. You initiate a $1000 trade that nets you 100 pips. In a $1000 trade, each pip is worth 10 cents. The profit from your trade would be $10 or a 1 percent gain. If you were to use that same $1000 to make a 50 to 1 margin trade giving you a trade value of $50,000, the same 100 pips would net you $500 or a 50 percent gain.
DisadvantagesThe disadvantage of using margin is risk. Let's make the opposite assumption that we made while discussing advantages. You are still using a $1000 account balance. You initiate a $1000 trade and lose 100 pips. Your loss is only $10 or 1 percent. This is not too terrible, you would have plenty of capital left to try again. If you were to make a 50 to 1 margin trade for $50,000 a loss of 100 pips takes $500 or 50 percent of your capital. One more trade like that and your account is finished. On the first example, you only lost $10 or 1 percent, you could make that same losing trade 99 more times before your account was empty.
Margin and LeveragesTrading currencies on margin lets you increase your buying power. This means that if you have $5,000 cash in a margin account that allows 100:1 leverage, you could trade up to $500,000 worth of currency because you only have to post one percent of the purchase price as collateral. Another way of saying this is that you have $500,000 in buying power. With more buying power, you can increase your total return on investment with less cash outlay. But be careful, trading on margin magnifies your profits AND losses.
All traders fear the dreaded margin call. A margin call forces the investor to either liquidate his/her position in the stock or add more cash to the account.This occurs when your broker notifies you that your margin deposits have fallen below the required minimum level because an open position has moved against you. Here's how it works. Let's say you purchase $20,000 worth of securities by borrowing $10,000 from your brokerage and paying $10,000 yourself. If the market value of the securities drops to $15,000, the equity in your account falls to $5,000 ($15,000 - $10,000 = $5,000). Assuming a maintenance requirement of 25%, you must have $3,750 in equity in your account (25% of $15,000 = $3,750). Thus, you're fine in this situation as the $5,000 worth of equity in your account is greater than the maintenance margin of $3,750. But let's assume the maintenance requirement of your brokerage is 40% instead of 25%. In this case, your equity of $5,000 is less than the maintenance margin of $6,000 (40% of $15,000 = $6,000). As a result, the brokerage may issue you a margin call.
Margin calls can be effectively avoided by monitoring your account balance on a very regular basis and by utilizing stop loss orders on every open position to limit risk. The topic of margin is a touchy subject and some argue that too much margin is dangerous. It all depends on the individual and the amount of knowledge and training he or she has. If you are going to trade on a margin account, it's vital that you know what your broker's policies are on margin accounts and that you understand and are comfortable with the risks involved.