Benefits and risks of margin trading
The benefits of trading on margin can be akin to turbo-charging a car. Your ‘engine’ (or buying) power is dramatically boosted for comparatively little initial cost – magnifying and intensifying performance.
In a bull market, the compounded gains can be spectacular. But, in a bear market margin accounts for CFD trading also enable you to ‘short’, so you can potentially gain from upwards and downwards price movements.
The maths might look like this:
You want to trade just £100. You are confident that the price of gold is going to rise. Your broker sets the margin for gold CFDs at 2%.
That means for your £100 you can trade in £5,000 of gold. That’s worked out as £100 divided by 2% = £5,000.
Let’s say you are right and the price of gold goes up 5% that day. Your trade closes at £5,250, making you £250 profit. And your £100 investment remains intact.
Margin trading gains can be significant, as is the sophisticated investing diversity on offer, enabling you to spread or ‘hedge’ your portfolio, without having to sell existing stock you may own.
Assuming your margin strategy works out, you also easily cover any ongoing expenses such as interest and commission.
When used responsibly and supported by careful research, margin trading can be highly profitable.
To be clear, margin trading involves risk and any margin loan (and interest) has to be repaid regardless of the value of the securities you buy on margin.
By definition, leverage trading means small or modest market movements can result in significant profits and losses. That means keeping a close eye on your account at all times.
Let’s look at that example again. Had the price of gold dropped by 5%, you would have made a loss of £250. As you had only paid £100 for the trade, your broker would take the other £150 from maintenance margin and you might even need to top that up.
You need to keep an eye on the trades and close them if they move against you or put in place automatic safety orders to close orders early.
Bear in mind that many novice traders start out with too little in their margin account, which can, in some circumstances, exaggerate their losses. Substantially funding your account at the start lowers your risk because it ups your safety ‘buffer’.
You do not want to be in a position where your broker has to sell your holdings quickly at a highly disadvantaged price with no chance for the price to recover.
- Different markets have their own distinct type of risk.
- Price volatility can be profound, especially when there is significant market, company or economic news, from a huge variety of sources.
- Currency volatility can have a huge effect on the profitability of your account or transaction.
- The currency or forex market is lightly regulated. While highly ‘liquid’ it’s not as transparent as traditional stocks and shares.
- Margin trading isn’t just used to trade smaller, less well-known stocks. It’s also used to trade blue chip stocks, which can introduce new risk levels to ‘safe’ stocks.
- Many city fund managers fail to outperform the market and most ordinary investors face the same challenges and conditions