What is Margin Trading ?
This post will discuss Margin Trading in detail. Its pros and cons are also covered at length.
Methods of Trading
There are 2 main ways to trade in the market:-
1. Cash Based
A trader deposits full value of the item he is trading. This mode is quite uncommon among traders as it is capital intensive.
2. Margin Based
As the name suggests, this trading is done on “Margins”. A trader opens a margin trading account with any exchange through a broker.
What is Margin Trading?
To better understand margin trading, let’s consider a simple example. A commodity is trading at 100 $ at Chicago Mercantile Exchange. Margin trading is allowed in this commodity. The exchange has set 5% margin for this item. It implies that in order to buy or sell 100 $ worth of this commodity, any trader must have a minimum deposit of 5 $ in his margin trading account.
Margin is also known as Initial Margin. So, the trader has bought 100 $ worth of commodity contracts by placing a mere 5 $ in his trading account. If he wants to enhance his holding to 200 $, he would simply deposit another 5 $ and purchase an additional 100 $ worth of this item and so on.
The concept of margin trading is quite simple to this extent. However, it gets tricky from hereon. Let’s assume the market price of that commodity drops to 98 $. How will this affect the margin trading account? The 2 $ drop in market price will eat into the 5 $ initial margin placed by the trader, which is now reduced to 3 $.
What is a Margin Call?
The balance in trader’s margin account has dropped from the mandatory 5 $ mark. This generates a “Margin Call” in his account. The broker concerned contacts the trader and informs him of this 2 $ shortfall. The trader has 2 alternatives at this stage; either he deposits an additional 2 $ in his trading account or he reduces his position.
The trader’s decision relies upon his perception about future price trend. If he thinks that this 2 $ drop in price from 100 $ is temporary, he will prefer to deposit an additional 2 $ to sustain his position. If he infers that this price drop is likely to continue or even escalate, he will be inclined to “book” this 2 $ loss and liquidate his position.
If the trader decides to add funds to his trading account to sustain this position and the price downfall continues, the above cycle of margin calls will continue and he would have to keep adding funds to the tune of subsequent margin calls.
If he decides not to add funds and book his losses, he would sell his position at 98 $ price. The balance in his margin trading account has now dropped to 3 $ from 5 $. Now, he would search for another trading opportunity and try to make up his losses elsewhere or at some other time.
Advantages of Margin Trading
• This provision enables traders with very small capital to actively participate in the market.
• Margin enables traders to take positions far exceeding their invested capital, anywhere between 20 to 1,000 times of their deposit.
• A good trade can result in landslide profits which are inconceivable in relation to one’s contributed capital.
Cons of Margin Trading
• Most traders fail to grasp the “gravity” of the situation that they are trading on such high risk.
• Risk is directly proportional to level of leverage but most traders do not see the flip side.
• A trader may get stuck in a bad trade and keep meeting his margin calls without realizing that booking his loss beyond a certain stage is a better alternative.
• Poorly managed margin accounts can potentially wipeout a trader’s entire capital.
• Overwhelming majority of margin traders are losers due to improper risk management.
How to manage a Margin Trading Account
As discussed earlier, allowed margins may range between 20 to 1,000 times of one’s actual investment. Apparently, this seems like a great money minting opportunity but most traders fail to see the flip side. There are 2 main strategies to better manage a margin trading account:-
1. Cautious Use of Margin
An exchange allows you to trade 20 times of your capital. Why utilize all of it? A trader should not exceed 2-5 times of his capital. Routine trading should be done only with your own capital without employing margin at all. If a good trading opportunity presents itself, it may be enhanced to 2-5 times to improve earnings prospects but not beyond that.
It has 2 key advantages, first being the total avoidance of troubling margin calls. Even if the price moves unfavorable, there would be ample cushion in the margin account to sustain this jolt. There is no question of auto/forced liquidation of the position as there is sufficient margin to avert this.
Lastly, if there is no margin call, the trader can easily avail small price swings by circulating his position repeatedly. This option is ruled out in case there is a margin call in the account. A position once liquidated under margin call cannot be rebuilt fully unless fresh margin is added.
2. Trading with strict Stop loss
This is another good strategy if margins are being heavily availed. If a trader has utilized most of his allowed margin, room for error is minimal. Under this condition, if the price moves slightly against the trader’s position, the account is likely to be wiped out. So, a strict stop loss should be employed so that the trading account does not sustain irreparable losses. By using this option effectively, you as a trader will live to fight another day.
What is Auto-Liquidation?
This is a closely related issue to margin trading. As per exchange laws, initial margin has to be fully maintained by all traders. Some traders tend to ignore margin calls in their accounts. So, exchanges have come up with auto-liquidation mechanisms. When the running margin in a trader’s account falls to a certain pre-defined threshold, an example can be 21% of required initial margin, the trader’s open position is auto-liquidated.
Auto-liquidation laws exist in all exchanges in some form or the other. They act as a last line of defense for the exchange and trader. The main purpose of auto-liquidation mechanisms is to come into play before a trading account goes into negative territory, after all the initial margin has been eroded.
Margin trading is a tricky affair and most traders jump into this arena without considering the pros and cons. It is a double edged weapon and must be used with extreme caution.
Guidelines for managing Margin Trading accounts are covered in detail.