‘Knowledge is Power, Power is Wisdom, Wisdom is understanding’ says Lilcent King. Inherent in the loins of knowledge is the quantum ability to conquer anything. What many people are oblivious to is the fact that wealth creation is dependent on the amount of knowledge you meddle in. It can also be said that knowledge is wealth and wealth is power, thereby equating knowledge to power and power to wealth.
The fundamental reason for trading the forex market is wealth creation or simply to make money. Most traders are fixated on developing strategies upon strategies, neglecting the understanding of some vital concepts such as margin trading, leverage, etc. without which one can easily blow their account or become less profitable.
This article seeks to highlight the concept of margin trading. While this concept may be new to some, others are yet to appreciate its vitality in their trading journey.
Margin Trading
Margin trading is a concept used in the financial world, in the forex market, stock market as well as in the commodity markets. It is also known as buying on margin. It boosts the purchasing power of traders and also increases their investments beyond what they could afford with their own money.
Therefore, margin trading gives traders the ability to enter into several trades and open several positions with just a small cash in the forex market. With this in view, huge profits are realized with just a small change in price in favor of their direction, but this can be dire when price goes otherwise. Normally you will see these things displayed on a margin trading account display: Balance, Used Margin, Free Margin, Unrealized P/L, Equity, Margin Level.
Margin, what is it?
To have an in-depth understanding of Margin trading, one key word to consider is Margin. The word Margin is simply the money one borrows from a broker to procure an investment. The margin can be calculated as the value of the investment minus the loan given by the broker. It serves as collateral by which an individual is allowed to take a loan from a broker.
The operation of Margin Trading
For traders to benefit from margin trading, they must open an account with their broker, referred to as a margin account. It is a standard account in which investors deposit their collateral (money) for a loan from the broker. The amount of money in that account is called the equity. Usually, when you register with a broker, an offer is given for the opening of this margin account, without which you can neither deposit cash nor borrow a larger amount of money from the broker for investment.
The money (collateral) one has in his margin account affords him the liberty to borrow up to 50% of the purchase price of an investment. For example, if your equity is $25,000, you could buy up to $50,000 of forex or stocks or commodities etc. you would be required to pay an interest on the loan. This interest is initially added to the margin balance and the profit from the trade or investment is used to pay for it and the rest becomes the investor’s gain.
It is important to know that irrespective of the rules and regulations of different brokers, margin trading is highly regulated by the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC). Below are some of these rules:
Minimum Margin
According to the law, every broker must seek the consent of their investors to open a margin account. This margin account may be part of your standard account opening agreement or may be a completely separate agreement. The minimum margin required by most brokers is $2,000.
Initial Margin
The initial margin is also known as the required margin, deposit margin, or entry margin. It is the amount of margin that is needed to invest in a specific currency pair. It is the percentage of the “full position” size or “Notional Value” of the position you wish to open. Every currency pair and their margin requirement. For example, the margin requirement for GBP/USD is 5%. If an investor wants to buy 10,000 of GBP/USD, without leverage, they are required to deposit $10,000. However, with a margin requirement of 5%, an investor needs only $500 to buy and maintain $10,000 of GBP/USD.
Maintenance Margin (Margin level) and Margin Call
The maintenance margin is the minimum account balance you must have to avoid being required by your broker to deposit more funds or to close some trades to pay down your loan. A margin call is therefore the event whereby a broker demands their investor to add money to their account or close out positions to bring their account back to the required level. Usually, if investors do not meet the margin call requirement, the broker closes out any open positions to bring the account back up to the minimum value. The broker does this without the approval of the investor and chooses which position(s) to liquidate, but the investor is responsible for any losses incurred during the process.
Pros and Cons of Margin Trading.
Pros
- It can result in loads of profit due to the leveraging factor
- Your purchasing power is greatly enhanced
- The flexibility of margin trading is better than other forms of loans
Cons
- On the other hand, margin trading can result in greater losses due to this same factor of leveraging.
- When your account balance falls below the margin requirement, you will experience a margin call to deposit more money to meet the margin requirement.
- The forced liquidation by brokers when the investor doesn’t meet the margin requirement after the margin call may happen without any further notification, leading to many losses.
- Margin trading comes at a cost. You are required to pay interest on the loan from the broker. The interest charged is dependent on the depends on the loan amount and market conditions at the time.
Conclusion
Whoever indulges in margin trading must have the requisite knowledge. It is a high-risk business and hence needs some experience applied. Inexperienced investors should use cash accounts to invest until they master the forex, commodity, or stock market, depending on their preference. Having enough cash on hand to cover potential losses will prevent investments from being liquidated in most instances.
