What is margin trading and what are its risks

What is Margin trading?

An investor can conduct transactions on the exchange not only with his assets. Quite often brokers and forex dealers are ready to lend their clients securities and money for trading on the stock exchange at a certain percentage. The person will not receive them to the account and, accordingly, will not be able to withdraw them from it, but he will have the opportunity to use them in transactions.

The investor's own assets serve as collateral — they guarantee that he will be able to pay off his intermediary. Such collateral is called margin, and the number that shows how many times the transaction amount will grow is called leverage. Therefore, operations in which the client uses the assets of a broker or forex dealer are often called margin trading, or trading with leverage. And margin transactions themselves are unsecured transactions.

If the transaction makes a profit, thanks to the leverage, it will increase significantly. But in case of failure, losses will grow in the same proportion.

Margin trading gives players a chance to earn not only on the growth, but also on the fall of the asset price. Let's say an investor assumes that the value of some of his securities will decrease. He sells them, and then buys them back again, but cheaper — and makes a profit due to the difference.

Margin trading "in short" allows you to earn money by selling even those assets that are not in your portfolio: you borrow them from a broker and sell them. If these securities become cheaper, later you buy them at a lower price and return them to the broker, and you take the difference between the cost of sale and purchase for yourself. But if the price rises, then instead of profit you will get losses: you will still have to return the securities to the broker, but you will need to pay more for them.

Please note that margin trading is not possible for all instruments. Brokers post a list of assets that can be bought or sold with leverage on their website or in the terminal.

Margin trading "short" always involves a reverse transaction. If you sell securities that you borrowed from a broker — in other words, you open a position, then after a while you have to buy them back and give them back — or close the position.

When you trade "long" and buy a certain amount of securities with leverage, you are not obliged to sell them later. You can simply top up your account to return the money to the broker.

How is the leverage determined?

Leverage shows the ratio of the investor's own assets to the transaction amount, taking into account the money or securities provided on credit.

How much money or securities the intermediary will lend depends on three factors.

1. Discount of the instrument

The minimum risk rate, or discount, for each instrument is calculated daily by clearing organizations. Brokers can set other discounts of securities for their clients, but they should not be lower than the exchange's figures.

When calculating the discount , the clearing organization takes into account:

  • liquidity of a security — the ability to sell it quickly at a fair price,
  • volatility — how sharply and strongly its price can change.

The harder it is to find a buyer and the greater the fluctuations in value, the higher the discount and the less leverage there will be for this instrument. To calculate the maximum allowable size of the transaction with leverage, the broker divides the amount of the client's own funds by the discount.

But for many investors, discounts on most instruments will be higher than the minimum, and leverage will be less than the maximum. It depends on another indicator — the level of risk that is assigned to the person himself.

2. Investor's risk level

It is determined by the broker. By default, when opening an account, a standard or initial risk level is automatically assigned to a new client.

An increased level of risk is received by an investor who has at least 3 million rubles in money or securities on a brokerage account. Or when it meets three requirements at once:

  • the amount of his assets in the account exceeds a certain amount.
  •  the investment account was opened more than 180 days ago,
  •  in at least five of these 180 days, he made deals.

For investors with an increased level of risk, a discount is used, which the clearing organization calculated for the instrument. And for less affluent and inexperienced clients, the broker will set a higher discount for each instrument.

Discounts on each paper and available transaction amounts, which already take into account the investor's risk level, can be viewed in the personal account on the broker's website or in your trading terminal.

3. Margin size

The broker calculates this indicator for the client before each of his transactions with leverage. Margin is the value of assets on the investor's account, taking into account the discount on them, which remains pledged to the broker. Only the most liquid instruments are summed up: money and securities that are easiest to sell — each broker publishes a list of them on its website.

As the profit or loss increases, the margin increases or decreases accordingly. But the broker usually makes sure that the margin does not fall below the minimum, which is guaranteed to allow the client to pay off the loan.

The broker determines the maximum amount of margin loan using the following formula: the margin size is divided by the discount of the instrument and then deducts the amount of the investor's own money. As the profit or loss increases, the margin increases or decreases accordingly. But the broker usually makes sure that the margin does not fall below the minimum, which is guaranteed to allow the client to pay off the loan.

In fact, there is no need to delve into the calculations of leverage and credit, taking into account margin and discount. When choosing a tool in the broker's terminal, you will already see exactly how many selected securities and for what amount you can buy in margin trading mode.

At the same time, it is not necessary to use the maximum available leverage, especially if you are just starting to trade. After all, leverage acts as a lever, multiplying both your profits and losses. For example, if you spend all your money on a transaction with a leverage of 1:10, and prices change by 10% in the wrong direction for you, then you will lose the entire amount on the account.

The maximum leverage in the forex market is determined by other rules: it is limited by law. The forex dealer has the right to provide leverage to qualified investors up to 1:50. For customers without the "qual" status, this proportion is less: the dealer calculates it daily based on the statistics of currency fluctuations for the previous 365 days. Most often, the shoulder is in the range of 1:15-1:35. This at least partially protects inexperienced investors from large losses.

What will happen if my securities fall in price and the margin decreases?

When this happens, the broker usually warns the client that he needs to replenish his account, otherwise the asset value may not be enough to close the position. Such a notification comes through a trading terminal or by e-mail, this is called a margin call.

Brokers themselves determine the level of losses at which they send a margin call. Some notify the client as soon as the margin decreases by at least a ruble. Others send a notification when the investor's own assets lose, for example, 50 or even 80% of the value. And some do not use margin calls at all, and in such cases investors risk even more — you can suddenly lose all your assets.

If the investor does not put money into the account and the losses reach a certain level (usually from 50 to 90% margin), the broker usually uses a stop-out — that is, forcibly closes positions to get their money back. The client will receive losses in this case.

In trading programs, brokers always indicate the minimum margin level of the client, at which they themselves will close his positions. But you need to keep in mind: brokers have the right to use a stop-out, but they are not obliged to use it. It may happen that the losses will cover the margin, and you will remain in debt to the broker. Therefore, you should not rely entirely on margin call and stop-out - it is important to monitor the state of your portfolio independently.

How much does a margin loan cost?

Usually, the loan fee is not charged when you use borrowed funds within one trading day. But if you hold the broker's money or securities for longer, he will write off the interest for using his assets. As a rule, the rates range from 15 to 20% per annum, or about 0.04%-0.05% per day. And in any case, you will have to pay a commission for transactions.
Brokers charge off a daily fee for a margin loan even on non-working days of the exchange. If you open positions for a long time, the loan rate can reduce all profits to zero. That is why transactions with leverage are usually concluded for a short period of time.

Are leveraged deals available to novice investors?

Margin trading involves high risks. Therefore, before you start trading with leverage, inexperienced investors need to be tested. As soon as you want to make the first margin transaction, the broker will offer you to take the test. It's free.

The questions will allow you to evaluate your knowledge. You need to give the correct definition of margin trading, answer whether the broker has the right to charge you for a margin loan, and estimate the amount of possible losses. You should also know in which case the broker can forcibly close the client's position.

Retake the test is allowed as many times as you want. But even if you fail to answer all the questions correctly, the broker may allow you to make unsecured transactions for a certain amount, warning about the risks.

Testing for access to margin trading on the forex market is more difficult. It has more questions than a stock market leverage trading test. And until you answer them correctly, you will not be allowed to make trades, as the risks of forex are especially high.

I passed the test. How do I get a margin loan?

Usually there is no need to issue any additional securities, since the possibility of margin lending is already spelled out in the brokerage agreement.

To use the broker's funds for transactions, it is enough to enable margin trading mode in the trading terminal. But it is important to be extremely careful: transactions with leverage are very simple. You can accidentally buy securities for a larger amount than you have, or even sell shares that you do not have, and only then realize that all transactions took place on credit.

It is better to disable the margin trading mode to eliminate the possibility of error and reduce the probability of losses, and enable it only in cases when you really need it.

If there are so many risks with margin trading, why are they needed? Can they be useful at all?

To successfully play on the rise or fall in the value of securities due to margin trading, you need to be an experienced trader. But there are situations when transactions with leverage carry not so many risks and can be useful even for novice investors.

Purchase before transferring money from the bank to the brokerage account

John has shares, he gets good dividends on them and would buy them more if they were cheaper. Suddenly, the price of the paper dropped to the one that John had just dreamed of. You need to act quickly, and he has a small amount on his brokerage account. By the time he transfers money from the bank, a day or two will pass and the situation may change again. And with a shoulder, you can buy papers right away and then calmly wait for the replenishment of the account.

Cash gap

John decided to sell shares and buy bonds of another bank instead — their price is very profitable now. According to the rules of the exchange, the money from the sale of shares will be credited to the account only two days after the transaction, and John is afraid that during this time the bonds will rise in price. With the help of a margin loan, he can invest in the securities of a new bank immediately. John will pay a small percentage for using leverage and return the debt to the broker as soon as the money for the shares comes to the account.

Buying before selling

John bought the bonds to the bank. But now he is thinking of changing them to more promising, in his opinion, shares of another bank. He could sell his bonds and put out a bid to buy shares. However, it is unknown when the price of the securities he needs will drop to this level. It is possible that John will have to keep a large amount of money in the account for a long time, which does not bring income.

Instead, John can hold the bank's bonds, receive interest on them and just wait for the shares of another bank to fall in price. And as soon as this happens, immediately buy new securities at the expense of a margin loan and sell unnecessary bonds to pay off the debt. If both transactions take place within one trading day, his broker will not charge for the loan.

But before any transactions with leverage, you should carefully weigh your benefits: will it be possible to save thanks to a margin loan, taking into account the fact that you will have to pay interest to the broker for it.

How can I reduce the risks if I still plan to conduct transactions with leverage?

Margin trading is in any case more risky than transactions with your own money, but you can reduce the risks:

  • Control your positions in the trading terminal so that you don't accidentally get into the shoulder when you don't want to.
  • Use stop loss (stop loss) — automatic exit from the transaction under certain conditions that you set yourself. For example, a position may close as soon as the asset price or your losses reach the limit you set. So you can at least not be afraid to go beyond the permissible losses. Usually, the stop loss option is configured in the trading terminal.
  • But keep in mind that a stop loss may not work - for example, if no one wants to buy or sell securities at the price you need on the market. In this case, the broker will not be responsible for not fulfilling your order.
  • Independently monitor the margin level for positions, even if the broker uses margin call and stop-out. If necessary, top up your account or exit transactions. Otherwise, you can not only lose all your assets, but also remain in debt to the broker.

If you decide to deal with margin trading, try never to use credit funds to the maximum. Remember that leverage can turn even a small wave in the market into a tsunami and reset your account.