Trading on Margin

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Prior to reading this section, you may find it useful to read the area of this website entitled "Contract for Difference (CFD) Trading." Examples used below assume you have an understanding of CFD's and have read the "Contract for Differences (CFD) Trading" Section prior to reading this section. You can read this section first by clicking HERE.

Initial Margin Example

When trading on Contract for Difference (CFD), you will be utilising what is termed as "Margin." Similar to Spread Betting, the broker will typically allow you to trade up to 10 times your initial deposit in Large Cap Stocks, Indices, Commodities and Bonds. On FOREX they will lend you typically up to 100 times your initial deposit. Your initial deposit is known as your "Initial Margin."

Let's go back to our Vodafone example. Remember the notional amount of this trade was £17,000. Let's say now that you deposit only £10,000 in your trading account? How is possible that you can participate in this £17,000 position? Well, the broker in this example will typically allow you to borrow up to ten times the amount you deposit on account to trade in Large Cap stocks. For the Vodafone position, this simply means you will be using a portion of your £10,000 on account as collateral against this position. If the broker lends 10 times for Vodafone, then when you enter the trade, you will be "utilising" £1,700 of your initial deposit i.e. 10% of your Initial Margin to this trade. The other £8,300 that is not utilised for Margin Trading can now be utilised to participate in additional trades. If in this example, the price of Vodafone goes in your favour by 10% i.e. the underlying stock goes to £1.87, you will receive an additional £1,700 on a Marked to Market" basis in your trading account. The new value of your trading account will be £11,700 - However if you lose 10% i.e. the underlying stock price of Vodafone goes to £1.53, the broker will take away £1,700 from your trading account leaving you with £8,300 available to trade on Margin with. This is what we mean when we say that that your initial deposit is used as collateral in your trading account to enable you to trade on Margin with. The £10,000 initial deposit (Margin), is used to cover any losses you may incur when trading on Margin.

Variable Margin Example

The amount you pay to cover your losses on a daily basis is called your "Variable Margin." Now let's assume in this example that Vodafone goes to zero i.e. the underlying Vodafone stock price goes to Zero. This means you will owe the broker £7,000 - You will get what is known in the industry as a "Margin Call" - Why is it termed in this way? It is because the Broker will literally send you an email and pick up the telephone and Call you to deposit more money into your trading account to cover the loss. Infact, in reality if Vodafone fell by 59% the value of your account would be zero. This is because you have taken a £17,000 position and deposited only £10,000 in your account as collateral to cover any losses. £10,000 is 59% of £17,000. Therefore if Vodafone fell by 59% i.e. the value of your Contract falls by 59%, your initial deposit would be wiped out and you would receive a "Margin Call" to deposit more money in your trading account to cover any further losses. if you cant stump up the cash, then the broker will trade out of the position on your behalf and crystallise the loss. In this instance you would be wiped out.

Basic Risk Managment Example

It may seem a little farfetched that a large cap stock like Vodafone could fall by 59% in value. You would be right. It is farfetched. But you are missing the point here. What usually occurs when Retail Traders are trading on Margin is that they will utilise all of the leverage they are offered by brokers. Retail Traders lack the discipline of Basic Risk Managment principles. This can be across one position or many positions. Now let's assume the Vodafone position is a £100,000 position. You would be utilizing the entire £10,000 of your Margin collateral to take this position. If Vodafone now fell by 10%, you would receive a Margin call. That's not so unrealistic. Retail Traders make this mistake all the time. They think that just because the broker offers them ten times what they have deposited on Margin, they have to utilise it all. This is not the case. Remember it is in the brokers interest that you do utilise all of the collateral you have to trade on Margin because they get paid commission on the notional amount of the trade. The more you trade, the more they get paid. This however may not be good for you in the long run as the underlying asset you are taking a position on may move against you very quickly and your account could be totally wiped out very quickly. Imagine if you did this in FOREX and leveraged 100 times! Your exposure would be £1,000,000. If the currency pair moved against you by 1% in one day, you could be wiped out in one day! 

If you would like to learn more about trading on Contract for Difference (CFD), please go to the area on this website entitled "Contract for Difference (CFD) Trading." Or to be redirected to this area please click HERE.

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CFDs are a leveraged product and can result in losses that exceed your initial deposit. Trading CFDs may not be suitable for everyone, so please ensure that you fully understand the risks involved.

 

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