Using margin for different asset classes
You can use margin to trade in most asset classes. You can, for example, invest directly in equities, buy your preferred shares and hold on to them until you are ready to sell.
You would need the share price gain to be enough to repay the broker, including interest, and still make a profit.
Assuming the shares you wanted to buy were in a leading company, the broker might ask for a 50% margin. Meaning, you might pay £50,000 and your broker would buy you £100,000 of shares.
A 20% rise in the share price would net you £20,000 in profit, actually, a little less after paying the interest and transaction fees. That’s not bad for a £50,000 investment!
The problem is that if the shares fall 20%, you’ve made a £20,000 loss, plus interest on the £50,000 borrowed and the transaction fees. That’s the danger with margin – you can reap huge rewards but face equally large losses.
Trading direct in shares on margin is for big-time, experienced investors, but the principle of margin trading works for small investors too, in trading financial instruments such as CFDs.
An investor who owns shares might trade CFDs as a hedge against the shares they own falling in price.
The investor would short using a CFD. Short selling shares means borrowing shares you don’t own and selling them at the current price (leaving you short) in the belief that the price will fall.
You then buy what you owe once the share price has dropped.
CFDs enable an investor to short cheaply because they do not have to borrow or own the shares.
What is a CFD?
A contract for difference (CFD) is a deal with a broker based on the gap between the buying and selling price of an underlying asset, such as a share or commodity. The contract is usually for a fixed time.
You never actually own the asset, so you do not pay its full price, or tax, when you sell. A CFD broker only charges a margin, say 5%, of the asset’s price. Some set a lower or higher margin for different assets. 2% to 20% is considered normal.
You can speculate that the price will rise (go long) or fall (go short). The exit is the price at the close of the day’s trading. Alternatively, you may set the price at which you enter and/or exit.
If the asset rises or falls more than you thought, you lose further advantage. But you are protected against the price falling, or bouncing back, after a spike.
You can hold CFDs for longer than a day but you will pay additional interest on your borrowing, typically near or at the interbank Libor rate. CFDs are also tax-efficient. There’s no stamp duty to pay. However, some brokers may charge you for opening and closing a CFD trade.
An investor sitting on 1,000 shares in company ABC, fearing the price is heading south, might make a CFD short trade in the same company.
If the price falls, the investor would lose money on the shares but recover it on the CFD trade (less the interest on the borrowed money and any transaction fees).
But investors do not just hedge against a share price movement. You can use margin to speculate that one currency will do well against another. You can speculate that a market index will rise or fall. You can speculate that the price of a commodity will go up or down.
Margin is not limited to a single asset class. All margin does is enable you to make a much more significant profit, or potential losses, from your trading.
Retail traders using margin
Simplified margin trading using automated systems online and on mobile apps are now available to retail investors, often based on CFDs. You might only need a small amount of money to begin trading, usually with trades closing at the end of the market’s trading day.
The systems are carefully regulated, often with a maximum leverage ratio set by regulators. You might not have as favourable margin ratios as a big investor who has a private margin account with a major broker, but entry is very straightforward.