What is Margin Trading? – Definition
How does margin trading work? – An example:
In the following, we would like to show you an example of margin trading. The trader has an account balance of $ 10,000. Now the trader wants to trade shares with a lever. The broker offers him CFDs (difference contracts) with leverage of 1:5 for shares. In theory, the trader can now buy or short shares worth 5 x $ 10,000 = $ 50,000. This makes little sense in our opinion because the entire account would be debited and the risk would be much too high.
The trader decides to buy the stock BMW at a price of $ 100 and 200 pieces of it (leverage 1:5). The total amount of the position is now $ 20.000. Thanks to the leveraged product only a security deposit of $ 4.000 is necessary. With a trading account of $ 10,000, you will need only $ 4,000 for trading 200 shares of BMW. The overall sum of the position is $ 20,000.
The share rises in one week directly by $ 10 to the price of $ 110 and the trader wants to close/sell the position. The profit is now 200 shares x $ 10 = $ 2.000. Thanks to the lever the trader could book a profit of 20% on his trading account. Without leverage product, the profit would be maximally $ 1000 because the trader could buy only for $ 10.000 shares.
See the example of the LEONI share:
It is possible to use your account balance as full margin but we do not recommend it because if you make a loss you will need additional money to keep the position open.
Example summarized (with numbers for easy understanding):
- Account size $ 10,000
- A trader buys 200 shares at a $ 100 price
- The total position size is $ 20,000
- Thanks to the leveraged product (leverage 1:5) only a security deposit (margin) of $ 4,000 are due
- The 200 shares rise to the price of $ 110 and are sold again
- The profit is 200 x $ 10 = $ 2,000
- Thanks to the leverage more shares could be bought and the profit is greater
What is a margin call?
A margin call is the worst scenario that can happen to a trader on the stock exchange. It means that losses occur and the trader’s account becomes smaller. Positions are still open on the market and the trader no longer has enough margin to cover the positions.
Now an automatic mechanism of the Online Broker engages and the positions are automatically stopped. It can vary from broker to broker at which level you are stopped. Some providers even allow you to over-stimulate the margin a bit. In summary, a margin call in most cases means the burial of your account balance, which is because of too big trading positions.
How does the broker make money with leveraged products?
Now many beginners will ask themselves: Why should the broker borrow money for my trading? – It is similar to a loan and I only need a small security deposit.
You have to understand that the online broker borrows the money when opening a position and gets the money back when closing the position. Various security mechanisms prevent the trader from being overindebted so that the position is stopped when the security has been used up. However, this happens only in extremely rare cases. You would have to leverage your trading account to do this.
The broker borrows money from larger banks (usually investment banks) and lends this money to the trader. In normal day trading, there are no interest costs for the trader. Only positions that are held overnight incur interest costs (swap). This results in an interest margin for the broker, who lends the money to the trader at higher interest rates.
This model is quite simple and easy to understand. It has many advantages because the trader can borrow and use capital very easily. The functions are automated.
Facts about online brokers:
- The Online Broker borrows himself money from banks
- The money is lent to the trader
- Interest costs are incurred only overnight
- The broker makes money on an interest margin and higher commissions through larger trading positions
The most popular leverage products:
Many leverage products are traded off-exchange. A contract is concluded between broker and trader. Now we will give you a brief overview of the most traded leverage products:
Forex (currency pairs):
Forex trading means trading currencies. The trader can bet on falling and rising exchange rates. Leverage is essential because volatility is very low. Liquidity is very high and trading is very transparent. Many brokers offer leverage of up to 1:500.
CFDs (Contract For Difference):
These contracts can be applied to any market. These include stocks, commodities, cryptocurrencies, and others. It is an over-the-counter trade. The advantage of this is that small stakes and high leverage are used. Short trades are also possible with this financial instrument.
Probably the oldest form of hedging on the stock exchange as a company. Prices are thus hedged for the future for the purchase or sale of a product. High leverage is possible here, but a lot of capital is needed.
Which provider and online broker is the best for margin trading?
With more than 9 years of experience in the financial markets, we have tested many online brokers who offer margin trading. In the table below, you will find our top 3 providers for leverage products. It is important for a trader that the provider is serious and has many years of experience in the market. The fees should also be very reasonable so that you do not experience any nasty surprises.
Setting up a margin trading account is pretty straightforward from our experience and has happened within a day. Alternatively, a free demo account can be used to thoroughly test trading platforms and financial products. Furthermore, the provider should have good support and educate you about all the risks involved in trading leveraged products.
1. IQ Option
Starting 1.0 pips
+ FX & Options
+ Best platform
+ Start with $10
Starting 0.0 pips
+ Individual offers
+ Trading signals
+ Personal service
Starting 0.0 pips + 3.5$ commission per 1 lot (XM Zero account)
+ Good conditions
+ 1,000 Assets
+ Personal service
Opportunities and risks in margin trading: Negative balance protection
High leverage can lead to considerable risks in the market. The high leverage allows the trader to open large positions. However, the trader himself is responsible for this. The trader must decide for himself which position sizes are suitable for the trading account.
In our opinion and view, very high leveraged positions are very bad for beginners and advanced traders and usually lead to large losses. You should stick to sensible risk management and not put your whole trading account in one position. In the past, there was an obligation to make additional payments and traders could overindebted themselves. Thanks to new regulations and safety precautions, there is on most brokers negative balance protection when trading CFDs (Contract For Difference). So they can no longer get into debt.
The leverage offers the trader the chance to make a higher profit. This can be used very specifically in certain trades. But the trader must also expect to make a loss. The higher the profit, the higher the risk. Traders should absolutely master good risk management and not open exaggerated positions.
- Margin trading opens up opportunities to make a higher profit.
- It is no longer possible to incur debts in CFD trading (no obligation to make additional contributions).
- Ignorant oversized positions can result in high loss
Conclusion: Our experiences with margin trading
Margin trading with leverage products gives the trader new opportunities to make a profit on the markets. For example, larger carry trades can be concluded (using the interest rate differential between currencies and earning interest daily in Forex).
Finally, the trader is still responsible for his profit and loss. Some traders blame too much leverage on their own failures and losses. This is complete misconduct because the trader determines the position size himself via the platform. The leverage product only gives you the chance to use more.
Finally, the risk increases through your own decision to trade the market. Margin trading is certainly no more dangerous than trading without a margin account. Use the leverage sensibly through good risk management decisions.
Margin allows you to make more profit through leveraged trading positions. But you should be aware of the risk which is increased.