Imagine this,
Sean predicts the GBP/USD market will experience an upward motion. With that, he wants to open a long position with 10,000 units at the current market price of 1.2000. Considering the position size and the market price, the notional value of his position is USD 12,000.
Here’s the question, does Sean have to use USD 12,000 to open his desired position and potentially trade from it?
Well, with margin trading, Sean can take full control over his trade with a smaller amount than the notional value.
Lesson Highlights
- Margin trading allows traders to access a position with high notional value using relatively small capital.
- Due to leverage, margin trading can be profitable because traders can control and profit from a larger position. However, it also magnifies the risk of wiping out a trader’s capital, even with a small market movement.
- If managed poorly, a margin position can subject traders to the risk of margin calls and even stop-outs, where a position is liquidated due to losses.
Margin Trading and Market Profits
One might say that margin trading is the most eye-catching and marketed feature of forex trading.
Like Sean, you’re up to facing the market even if your account balance is not enough to cover your whole position. If the market moves in your favor, your position will gain bigger profits than you could originally have gotten with your capital.
But don't forget that margin trading is a double-edged sword. For all its convenience and advantages, you can experience significant losses if you fail to manage it.
Remember, margin trading your way to success is never true. You don’t want to experience margin calls and stop-outs.
To mitigate and manage margin trading risks, you need to know how to capitalize on margin and be disciplined when using it.
Set Up Limits and Stop-Loss Orders
Setting up orders will be your best friend when you’re margin trading, especially the limit and stop orders. These orders can mitigate potential losses when the market goes against your position.
With limit and stop orders, your position is guided to execute trades at the best price while effectively managing the market risks.
When you set up a limit order, you specify the maximum price to buy and the minimum price to sell the position. This helps you execute precise entry and exit points, which is crucial when you're trading with margin.
If you want to execute orders automatically, the best route is to use stop-loss orders. These orders are best for risk management, as the platform will automatically exit a position when it reaches your stop-loss level.
This order is essential when you’re margin trading because you don’t want to risk your whole position and receive a margin call.
Disadvantages of Margin Trading
Margin trading is not all rainbows and butterflies. It comes with its own set of drawbacks, which can break your trade if you’re not ready for them.
Here are some disadvantages of margin trading. Make sure you know them before you leverage your trade.
Amplified Losses
Margin trading can give you more profit than your initial capital could have. However, you should know that leverage can drag your capital and account equity down the drain.
When you use a leverage of 1:100 for a notional position value of USD 100,000, you’re only putting on USD 1,000 for the position.
However, with a volatile market, even small changes in the whole USD 100,000-worth asset have a considerable impact on your USD 1,000 capital.
If the USD 100,000 asset experienced USD 650 in losses, all the losses will be deducted from your USD 1,000 capital.
Emotional Pressure
The emotion you have when you’re trading is something that would hinder you from achieving success. When margin trading, that emotion will inevitably intensify.
The pressure of amplified losses can lead to emotional decision-making, such as panic selling or neglecting risk management strategies.
Interest Rates
When margin trading, you’re basically borrowing funds from your broker. With that, you can expect your brokers to set interest rates on every leverage you take.
The rate varies depending on your margin loan size. The margin rate calculation is usually on your broker’s website. If it isn't, you can contact the broker and ask for the calculation.
If your position loses, the interest costs will accumulate, adding to your equity's overall losses.
Note: Your account balance has a direct impact on your margin rate. If a large amount of your money is with the broker, your interest rate will be lower.
Risk of Margin Trading
Throughout this lesson, you've walked through the risky potential of margin trading, but you haven't yet reached the deadly potential of this type of trading.
Here are the two trading events you'll probably encounter if you fail to properly manage your margin trade.
Margin Calls
Before you trade on margin, your broker will ask you to put a required minimum level of equity in your margin account. Considering that you have an open position, your account’s equity must float above the minimum equity level to support your trade.
If the position's value falls to a point where the equity is below this threshold, a margin call is triggered.
When you receive a margin call, your broker basically demands that you put additional money into your margin account so you can continue supporting your position. If you fail to deposit funds for the margin call, your broker will force you to sell your position, which translates to a significant loss.
Stop-Out
The stop-out is the indication that signals your broker to seize your account. This step is the end of the line in margin trading.
This occurs after the margin call or when you fail to deposit the required funds into your margin account.
The moment you’ve reached your stop-out level, the broker will start to liquidate your positions one by one. The reason behind the liquidation of positions is to balance out your account’s margin level.
If you’re facing a stop-out situation, what you can do is either fund your trading account, close some of your trades to support the profitable position, or close all your positions and accept your defeat.
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