What is Margin Trading?
Using margin in forex trading is a new concept for traders and often misunderstood. Margin is a good faith deposit that a trader puts up for collateral to hold open a position instead of putting up the entire money. It is often mistaken as a fee to a trader. It is actually not a transaction cost rather a sum of money kept aside and allocated as a margin deposit. The way margin is determined is based on the leverage that you choose. Margin is typically expressed as a percentage.
Because of the heightened risks margin trading is conducted in a type of account called the margin account which differs from the regular cash account of a trader. Margin trading is best left for sophisticated traders and high-net worth investors who are conversant with its risks. The average investor will be better off investing for the long term in a cash account, rather than trading for the short-term in a margin account.
Which securities can be traded on Margin?
Almost every security can be trader on margin account. It may be stocks, futures, commodities and currency. In cash market, usually brokers provide the margin and would charge a nominal interest. While for Futures market, exchange provides the margin and there is no interest charged. Every broker and exchange has different margin policies.
Advantage of Margin Trading:
- Leverage your gains– Buying shares on margin enables you to leverage your gains by buying more shares than you could in cash account.
- Diversify your portfolio– Used judicially, margin account can be used to hedge your portfolio. It you’re highly concentrated in few stocks than your margin account will help to add a position in other stock in order to improve diversification.
- Take advantage of trading opportunities– Trading shares on margin allows you to take advantage of trading opportunities as they arise, without having to raise cash by divesting your existing investments or from other sources.
Risks involved in Margin Trading:
- Interest charges and rate risk– Margin accounts have fairly high rate of interest. The interest cost can add up in margin account over time and erode the gains made in margined securities. Moreover, interest rates are not fixed but can fluctuate from time to time.
- Portfolio monitoring– Margin trading requires the traders to be vigilant in monitoring the margin account to ensure margin doesn’t fall below the required level. This can be very stressful during those periods when the market is highly volatile.
- Margin call– If the securities bought on margin face a sudden decline then the trader is faced with a margin call and have to bring a substantial amount of cash at a short notice.
Undoubtedly, margin trading helps budding traders and investors to invest with low funds. But traders should also be careful while choosing their deals because the loss is just as amplified as the profit. One should evaluate the risk before trading for the best results even when the market is volatile.