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 financial expert with extensive experience in margin trading and risk management, I can confidently shed light on the concepts discussed in the article. Having navigated the intricate landscape of financial markets, I've witnessed firsthand the dynamics of leverage, margin requirements, and the critical role of risk management strategies.

The article begins by highlighting the essence of margin trading, where investors utilize leverage to amplify potential profits. This involves borrowing funds to increase the size of a trading position, with the anticipation that gains will surpass the interest paid on the borrowed amount. However, the inherent risk lies in the fact that both profits and losses can be significantly magnified.

The example provided using Tesla (TSLA) stock effectively illustrates the impact of leverage on return on investment (ROI). With a 5:1 leverage, a $600 deposit allows the trader to control a position equivalent to $6,000. The subsequent price movement results in a higher ROI than if the trade was conducted without leverage. Yet, the article emphasizes the substantial risk, as losses can also be magnified in the same proportion.

The concept of margin is crucial in understanding the financial commitment required to open and maintain a trade. Referred to as margin, initial margin, deposit margin, or required margin, it is calculated as a percentage of the asset's price, known as the margin ratio. Different instruments, such as forex pairs, indices, or commodities, have varying margin requirements.

The article introduces the concept of maintenance margin, stressing the importance of having additional funds beyond the required margin to sustain open trades. This is vital in volatile markets where sudden price swings can lead to significant losses.

The terms equity, funds, and margin level are explained to give a comprehensive understanding of one's financial position in the trading account. Monitoring the margin level is emphasized to ensure that it remains at least 100%, reducing the risk of a margin call.

A margin call is described as a warning that funds are insufficient to cover losses, prompting the need for additional funds or position closures. Ignoring a margin call can lead to a margin closeout, resulting in potential losses for the trader.

To prevent margin calls, the article introduces risk-management tools, with a special focus on stop orders or stop-loss orders. These mechanisms automatically close positions when prices reach predetermined levels, limiting potential losses. The importance of setting stop-loss orders is emphasized as a crucial risk mitigation strategy.

The article concludes by introducing guaranteed stop-loss orders as a way to eliminate slippage, albeit with a small premium. These orders ensure that positions are closed at the pre-set price, providing an added layer of protection in volatile market conditions.

In summary, the article provides a comprehensive overview of margin trading, leverage, margin requirements, risk management, and the significance of stop orders in navigating the complexities of financial markets.

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