What is margin trading and what are its risks

Alexey opened a brokerage account six months ago and managed to make good money. Until now, he has bought securities only with his own money, and now a friend is agitating him to try transactions with leverage – that is, at the expense of the broker’s money. This is called margin trading, and it supposedly can bring in many times more profit. Is it worth starting such experiments for a not very experienced investor and what can they lead to?

What is margin trading and what are its risks

An investor can conduct transactions on the exchange not only with his assets. Quite often, brokers and forex dealers are ready to lend their clients securities and money for trading on the stock exchange at a certain percentage. A person will not receive them on the account and, accordingly, will not be able to withdraw from it, but he will have the opportunity to use them in transactions.

The investor’s own assets serve as collateral – they guarantee that he will be able to pay off his intermediary. Such a deposit is called margin, and the number that shows how many times the transaction amount will increase is called leverage. Therefore, operations in which the client uses the assets of a broker or forex dealer are often called margin trading , or trading with leverage . And the margin transactions themselves are unsecured transactions.

If the deal makes a profit, thanks to the leverage, it will increase significantly. But in case of failure, losses will also increase in the same proportion.

Alexei bought Superbank shares for 100,000 rubles. During the day, these securities rose in price by 2%. Alexey sold them and earned 2,000 rubles. If he borrowed 400,000 rubles from a broker and also bought Superbank papers with them, his total income would be 10,000. But if the shares fell in price by the same 2%, he would lose not 2,000, but 10,000 rubles.

Margin trading gives players a chance to earn not only on the growth, but also on the fall of the asset price. Suppose an investor assumes that the value of some of his securities will decline. He sells them, and then buys them back, but cheaper – and makes a profit from the difference.

Operations in a rising market are called “long” trading, and in a falling market – “short”.

Margin trading “short” allows you to earn by selling even those assets that are not in your portfolio: you borrow them from a broker and sell them. If these papers get cheaper, you later buy them at a lower price and return them to the broker, and keep the difference between the sale and purchase price. But if the price rises, then instead of profit you will receive losses: you still have to return the securities to the broker, but you will need to pay more for them.

Aleksey is confident that TaxebeBank’s shares will become much cheaper in the near future. He does not have these securities, and he borrows 1,000 shares of 350 rubles each from a broker, sells them and receives 350,000 rubles. Three days later, the paper really falls in price to 300 rubles per share. Aleksey buys a thousand shares of TaxebeBank to return them to the broker, but for 300,000 rubles. As a result, 50,000 rubles remains for Alexei. True, he will have to pay the broker a commission for transactions and a percentage for using borrowed assets – in the amount of about 700 rubles.

But if, contrary to Alexey’s expectations, the shares had risen in price to 380 rubles, he would have had to pay 380,000 rubles for them and at the same time lose 30,000 rubles on the transaction and 700 rubles on commissions and interest.

Please note that margin trading is not possible for all instruments. The list of assets that can be bought or sold with leverage is posted by brokers on their website or in the terminal.

Margin trading “short” always involves a reverse transaction. If you sell securities that you borrowed from a broker – in other words, open a position – then after a while you must buy them back and give them back – or close the position.

When you trade “long” and buy a certain amount of leveraged securities, you are not obliged to sell them later. You can simply fund your account to get your money back to the broker.

How is leverage determined?

Leverage shows the ratio of the investor’s own assets to the amount of the transaction, taking into account the money or securities provided on credit.

Alexey has 100,000 rubles to buy shares. The broker is ready to lend him another 400,000 rubles so that the transaction amount is 500,000 rubles. In this case, the leverage will be 1:5.

How much money or securities the intermediary will lend depends on three factors.

one.Tool discount

The minimum risk rate, or discount , for each instrument is calculated daily by clearing organizations . For example, for securities traded on the Moscow Exchange, discounts are determined by the National Clearing Center (NCC). Brokers can set other discounts for securities for their clients, but they should not be lower than the stock exchange figures.

When calculating the discount, the clearing organization takes into account:

  • liquidity of a security – the ability to quickly sell it at a fair price,
  • volatility – how sharply and strongly its price can change.

The more difficult it is to find a buyer and the greater the price fluctuation, the higher the discount and the less leverage for this instrument. To calculate the maximum allowable size of a leveraged trade, the broker divides the amount of the client’s own funds by the discount.

NCC set a discount of 0.2 for Superbank shares. If Aleksey had 1 million rubles in his account, he could buy shares for a maximum of 1,000,000 / 0.2 = 5,000,000 rubles using a margin loan. That is, the maximum leverage for this instrument is 1:5.

But for many investors, discounts for most instruments will be higher than the minimum, and the leverage will be less than the maximum. It depends on another indicator – the level of risk that is assigned to the person himself.

2.Investor risk level

It is determined by the broker. By default, when opening an account, a new client is automatically assigned a standard, or initial, risk level.

An increased level of risk is received by an investor who has at least 3 million rubles in money or securities on a brokerage account. Or when it  meets three requirements at once :

  • the amount of his assets in the account exceeds 600,000 rubles,
  • the investment account was opened more than 180 days ago,
  • on at least five of those 180 days he made trades.

For investors with a higher level of risk, the discount calculated by the clearing organization for the instrument is used. And for less wealthy and inexperienced clients, the broker will set a higher discount for each instrument.

Alexey has been actively trading for more than six months, but he has only 100,000 rubles on his account. So, he has a standard level of investor risk. He wants to buy shares of Superbank, to which the NCC assigned a discount of 0.2, but the broker determined it for Alexey at the level of 0.4. As a result, the transaction amount cannot exceed 100,000 / 0.4 = 250,000 rubles. That is, the maximum leverage will be 1:2.5.

Discounts for each security and available transaction amounts, which already take into account the investor’s risk level, can be viewed in your personal account on the broker’s website or in your trading terminal.

3.Margin size

The broker calculates this indicator for the client before each of his transactions with leverage. Margin – the value of assets on the investor’s account, taking into account the discount on them, which remains pledged to the broker. Only the most liquid instruments are summed up: money and securities that are easiest to sell – each broker publishes their list on their website.

Alexei bought shares for 100,000 rubles and deposited another 100,000 rubles into a brokerage account. Purchased shares are taken into account when calculating the margin with a discount of 0.5. Therefore, the broker evaluates them not at the current market value, but with a coefficient of 0.5. That is, the margin was: 100,000 (money in the account) + 50,000 (value of shares, taking into account the discount) = 150,000 rubles.

As profits or losses rise, margins rise or fall accordingly. But the broker usually makes sure that the margin does not fall below the minimum, which is guaranteed to allow the client to pay off the loan.

The maximum margin loan amount is determined by the broker using the following formula: the margin is divided by the discount of the instrument and then the amount of the investor’s own money is subtracted.

Alexey wants to buy Superbank shares, which have a discount of 0.4. Alexey has 100,000 rubles on his balance sheet, but taking into account other securities in his account, the broker estimated the margin at 150,000 rubles. This means that he can spend a maximum of 150,000 / 0.4 = 375,000 rubles on Superbank shares. Of these, 100,000 will be invested by the broker himself and 275,000 rubles will be borrowed by the broker.

In fact, there is no need to delve into the calculations of leverage and credit, taking into account margin and discount. When choosing an instrument in the broker’s terminal, you will already see exactly how many selected securities and for what amount you can buy in the margin trading mode.

However, it is not necessary to use the maximum available leverage, especially if you are just starting to trade. After all, leverage acts like a lever, multiplying both your profits and losses. For example, if you make a deal with all your money with a leverage of 1:10, and prices change by 10% in an unfavorable direction for you, then you will lose the entire amount on your account.

The maximum leverage in the forex market is determined by other rules: it is limited by law . A forex dealer has the right to provide a leverage of up to 1:50 to qualified investors . For customers without the status of “quala” this proportion is less: the dealer calculates it daily based on the statistics of currency fluctuations for the previous 365 days. Most often, the leverage is in the range of 1:15–1:35. This at least partly protects inexperienced investors from big losses.

What happens if my securities fall in price and the margin decreases?

When this happens, the broker usually warns the client that he needs to fund his account, otherwise the value of the assets may not be enough to close the position. Such a notification comes through the trading terminal or by e-mail, this is called a margin call.

Brokers themselves determine the level of losses at which they send a margin call. Some notify the client immediately, as soon as the margin decreases by at least a ruble. Others send a notification when the investor’s own assets lose, for example, 50 or even 80% of the value. And some do not use a margin call at all, and in such cases, investors risk even more – they can suddenly lose all their assets.

If the investor does not put money into the account and the losses reach a certain level (usually from 50 to 90% of the margin), the broker, as a rule, uses a stop out  – that is, it will forcibly close positions in order to return their money. In this case, the client will receive losses.

Alexei bought shares of Superbank with a leverage of 1:2.5 for 375,000 rubles in the hope of their growth. His margin was 150,000 rubles. However, after a couple of days, the bank’s shares began to rapidly fall in price. The broker sent a margin call, but Alex missed the notification. When the share price fell by 20%, the broker himself sold all the Superbank shares that were on Alexey’s account. By this point, he had lost 75,000 rubles – half his margin.

In trading programs, brokers always indicate the minimum margin level of the client, at which they themselves will close his positions. But you need to keep in mind: brokers have the right to use a stop out, but they are not required to use it. It may happen that losses cover the margin, and you will remain in debt to the broker. Therefore, you should not rely entirely on margin calls and stop outs – it is important to independently monitor the state of your portfolio.

How much does a margin loan cost?

There is usually no charge for a loan when you use borrowed funds within the same trading day. But if you hold the broker’s money or securities longer, he will write off interest on the use of his assets. As a rule, rates range from 15 to 20% per annum, or about 0.04%-0.05% per day. And in any case, you will have to pay a commission for transactions.

Alexey’s broker takes a commission of 0.05% for each purchase and sale of securities and 0.04% per day of the amount of money or asset value he lends. For a margin trade with Superbank shares, Alexey had to pay: 375,000 × 0.05% (for the purchase of securities) + 300,000 × 0.05% (for the sale) + 275,000 × 0.04% x 3 days (for a loan) = 670 rubles. And at the same time, the deal itself brought him 75,000 rubles of losses.

Brokers charge a daily margin loan fee even on non-working days of the exchange. If you open positions for a long time, the credit rate can reduce all profits to zero. That is why transactions with leverage are usually concluded for a short time.

Are leveraged deals available to novice investors?

Margin trading is associated with high risks. Therefore, before you start trading with leverage, inexperienced investors need to be tested . As soon as you want to make the first margin trade, the broker will offer you to pass the test. It’s free.

Questions will assess your knowledge. You need to give the correct definition of margin trading, answer whether the broker has the right to charge you for a margin loan, and estimate the amount of possible losses. You also need to know in which case the broker can forcibly close the client’s position.

You can retake the test as many times as you like. But even if you do not manage to answer all the questions correctly, the broker may allow you to make unsecured transactions in the amount of up to 100,000 rubles, warning you of the risks.

Testing for access to margin trading in  the forex market is more difficult. It has more questions than the Leveraged Stock Market test. And until you answer them correctly, you will not be allowed to make transactions, as the risks of Forex are especially high.

You can learn how to prepare for testing and where to start learning from the text “Where to learn to invest” .

I passed the test. How to get a margin loan?

Usually, you do not need to draw up any additional paperwork, since the possibility of margin lending is already spelled out in the brokerage agreement.

To use the broker’s funds for transactions, it is enough to activate the margin trading mode in the trading terminal. But it is important to be extremely careful: transactions with leverage are very simple. You can accidentally buy securities for more than you have, or even sell shares that you do not have, and only then realize that all transactions took place on credit.

It is better to turn off the margin trading mode to eliminate the possibility of error and reduce the likelihood of losses, and turn it on only when you really need it.

If there are so many risks with margin trading, why are they needed? Can they be useful at all?

To successfully play on the rise or fall in the value of securities through margin trading, you need to be an experienced trader. But there are situations when transactions with leverage carry not so many risks and can be useful even for novice investors.

Purchase before transferring money from the bank to the brokerage account

Alexey has shares in Superbank, he receives good dividends on them and would buy them more if they were cheaper. Suddenly, the price of the paper fell to the one that Alexei had just dreamed of. You need to act quickly, and he has a small amount in the brokerage account. While he transfers the money from the bank, a day or two will pass and the situation may change again. And with leverage, you can buy securities immediately and then calmly wait for the account to be replenished.

Cash gap

Aleksey decided to sell Superbank shares and buy TaxebeBank bonds in return – their price is now very profitable. According to the rules of the exchange, the money from the sale of shares will be credited to the account only two days after the transaction, and Alexey is afraid that bonds will rise in price during this time. With the help of a margin loan, he can invest in Taxebe Bank immediately. Alexey will pay a small percentage for using the leverage and return the debt to the broker as soon as the money for the shares comes to the account.

Buy before sell

Aleksey bought bonds of TaxebeBank. But now he is thinking of changing them for more promising, in his opinion, shares of Acceptable Bank. Now the papers of Acceptable Bank cost 120 rubles apiece, while Alexey would like to buy them for 100 rubles. He could have sold his TaxebeBank bonds and placed a bid for the shares of Acceptable Bank at 100 rubles. However, it is not known when the price of the securities he needs will fall to this level. It is possible that Alexey will have to keep a large amount of money in the account for a long time, which does not bring income.

Instead, Aleksey can hold TaxebeBank bonds, receive interest on them and simply wait for Primlemo-Bank’s shares to fall in price. And as soon as this happens, immediately buy new securities with a margin loan and sell unnecessary bonds to pay off the debt. If both trades go through within the same trading day, his broker will not charge for the loan.

But before any transactions with leverage, you should carefully weigh your benefits: will it be possible to save money thanks to a margin loan, given that you will have to pay interest to the broker for it.

How can I reduce risks if I still plan to trade with leverage?

Margin trading is in any case more risky than transactions with your own money, but you can reduce the risks.

  • Control your positions in the trading terminal so that you don’t accidentally get into your shoulder when you don’t want to.
  • Use stop loss (stop loss) – automatic exit from the transaction under certain conditions that you set yourself. For example, a position can be closed as soon as the price of an asset or your loss reaches the limit you set. So you can at least not be afraid to go beyond the allowable losses. Usually the stop loss option is configured in the trading terminal.
  • But keep in mind that a stop loss may not work – for example, if no one wants to buy or sell securities at the price you need in the market. In this case, the broker will not be responsible for not fulfilling your order.
  • Track the margin level on positions yourself, even if the broker uses a margin call and a stop out. If necessary, replenish your account or exit trades. Otherwise, you can not only lose all your assets, but also remain in debt to the broker.

If you decide to deal with margin trading, try to never use leveraged funds to the maximum. Remember that leverage can turn even a small wave in the market into a tsunami and reset your account.

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