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Margin Trading

What is margin trading?

"Margin" literally means a difference, or reserve. In this sense, margin trading is trading using a security deposit of money (which serves as collateral and is held in the client’s trading account). The margin is defined as a percentage of the total value of the trade; for example, a 1% margin of a $1,000 position is $10.

How to trade on margin?

On margin you can trade Forex, precious metals; CFDs on shares, indices, futures or other assets. The key feature of margin trading is that if, for example, you want to buy 100 Coca-Cola (KO) shares, provided the price of one share is $42.60, you do not need to have the full amount of $4,260, but only the part of it required as collateral: e.g. 5%, or $213.

Example 1: trading shares

If for example, the required margin is 5%, you need to have $5 in your account in order to buy shares worth $100. When a deal is closed, the client’s account undergoes certain changes:

Let’s say you have $1,000 and want to buy 100 Coca-Cola shares. The price per share is $42.60, and therefore the total transaction value would be $4,260. If the required margin is 5%, then the amount you should have in your account is $213 (4260 x 5%). This means that this amount remains blocked in your account, and the remaining $787 are available for trading.

If the share price increases by $1.40 to $44, you will realise a profit of $140. These $140 are added to your account and you now have $1,140, with the blocked amount being $220 (100 x $44 x 5%) and the free margin: $920.

Now you have two options:

  • Sell your shares at the current market price of $44, in which case your account equity will remain at $1,140,
  • or hold on to your shares in anticipation of a more favourable price (such as the share price increasing to $45, which will bring you an additional $100 – but at the risk of a price drop).

If instead of climbing by $1.40, the share price drops by $1.60 to $41.00, then you would lose $160. These $160 will be reflected in your account balance, which will now be $840. The blocked amount will be $205 (100 x $41.00 x 5%), and the free funds will be $635.

Now you have two options:

  • Sell your shares at the current market price of $41 in order to minimise higher future losses, in which case your account equity will remain at $840,
  • or hold on to to your shares in anticipation of a more favourable price – but at the risk of a further price drop.

Example 2: trading currencies

Let the required margin be 1% and your account balance $1,000. Currencies are traded in lots, and in the Delta Trading platform, 1 lot equals 1,000 units of the base currency. So, if you want to buy 20 lots GBP/USD, or £20,000, at a market exchange rate of 1.2450, you need to have $249.00 in your account available as margin (£20,000 x 1.2450 x 1% = $249.00). The remaining $751.00 are free funds that you could use to trade other financial instruments.

In case the market exchange rate increases to GBP/USD 1.2500, you will realise a profit of $100.00, which will be added to your account, giving you an account equity of $1,100.00. Therefore, the margin required for holding your position will become $250.00 (£20,000 x 1.2500 x 1%), and the free funds in your account will now be $850.00 ($1,100.00 – $250.00).

Now you have two options:

  • Close the position at the current exchange rate of GBP/USD 1.2500 and have your account balance grow to $1,100,
  • or keep the position open in anticipation of a more favourable exchange rate (such as the pound appreciating to GBP/USD 1.2550, then you will realise a profit of $200.00 – but at the risk of a price drop).

In case the pound depreciates to GBP/USD 1.2400, then you will lose $100, which will be reflected in your account. Therefore, the margin requirement will become $248.00 USD (£20,000 x 1.2400 x 1%), and the available funds will be $752, to give you an account equity of $900.0.

Now you have two options:

  • Close the position at the current exchange rate of 1.2400 in order to minimise higher future losses, in which case your account equity will remain at $900.00,
  • or keep your position open in anticipation of a more favourable exchange rate – but at the risk of a further drop in the GBP/USD rate.

Example 3: trading indices

Let us assume that the required margin is 1% and you have $2,000 in your account. You would like to buy a CFD on 1 US30 index at a market price of $18,170. In order to execute the trade, you need a margin of $181.70. The remaining $1,818.30 are available funds that you could use to trade other financial instruments. In case the market price increases to $18,500, the $330 profit will be added to your account. The blocked amount will increase to $185 ($18,500 х 1%), and the total account balance will become $2,330, $2,145 of which will be free funds available for other trades.

Now you have two options:

  • Sell the CFD on the index at the current price of $18,500 and realise a profit of $330, which will be added to your current account balance,
  • or hold on to it in anticipation of a price increase (such as the price of the index increasing to $18,650. In this case, you will realise a profit of another $150 – but at the risk of a fall in the price of the underlying index).

In case the market price of the index falls to 18,000, you will lose $170, which will be deducted from your account. The funds blocked as margin will become $180 (18,000 x 1%), and the available funds will shrink to $1,650, which would give you an account equity of $1,830.

Now you have two options:

  • Sell the CFD on the index at the current price of $18,000 in order to minimise higher future losses, in which case your account equity will remain $1830,
  • or keep your position open in anticipation of a more favourable price – but at the risk of a further drop in the price of the underlying index).

Positions

A position is a financial commitment to a particular financial instrument.

It can be viewed from different aspects:

- Speculative or hedging: A speculative position is the position in which you enter the market with the expectation of realising significant profits, taking into account the risk of losing the whole or most of the investment amount. A hedging position is a position where there is no exposure to risk factors, or exposure to them has been minimised. The purpose of opening a hedging position is to compensate the impact of unfavourable price movements of an asset in another position.

- Long or short: A long position is the buying of a certain financial instrument with the expectation that its value will rise. A short position is the selling of a certain financial instrument with the expectation that its value will fall.

- Winning or losing


Selling: Going Short; Buying: Going Long

When you buy a financial instrument, you are said to be “long” in that instrument. Long positions are placed at the ”Ask” price. Therefore, if you buy 1 lot GBP/USD lot quoted at 1.3280/83, then you are buying 1,000 GBP at 1.3283 USD.

When you sell a financial instrument, you are said to be “short”. Short positions are entered into at the “Bid” price, which in this case is 1.3280 USD.

Because of symmetrical currency transactions, you are always simultaneously long in one currency and short in another. For example, if you exchange 100,000 GBP for USD, you are short in British pounds and long in US dollars.


Closing a Position

We have an open position when we have a claim or obligation in a certain financial instrument. The value of the position will change relative to the market movement. Any potential profits and losses will be reflected in your trading account.

To close your position, you have to place an equal and opposite trade in the same financial instrument. For example, if you are holding a long position in 1 lot GBP/USD opened at the Buy price, you can close that position by selling 1 lot GBP/USD at the Sell price.


Betting on a Market Rise

Let us presume that you start trading at a current GPB/USD rate of 1.3280/83

  • You expect the pound to appreciate against the dollar, so you buy 100,000 GBP at 1.3283 USD.
  • The value of the contract is 100,000 X 1.3283 USD = 132,830 USD.
  • The GBP/USD duly appreciates to 1.3300/03 and you decide to close your position by selling your pounds for dollars. Your profit is:
    100,000 X (1.3300 – 1.3383) USD = 170 USD
  • You earn 170 USD on an exchange rate movement by less than 1%. This illustrates the positive effect of buying on margin.
  • On the other hand, if the GBP/USD falls to 1.3250/53, your loss will be:
    100,000 X (1.3250 – 1.3283) USD = - 330 USD

The conclusion is that margin trading may magnify the amount of both your profit and loss.


Betting on a Market Fall

Let us presume that you start trading at a current GPB/USD rate of 1.3280/83.

  • You expect the pound to decline against the dollar, so you sell 100,000 GBP at 1.3283 USD.
  • The value of the contract is 100,000 X 1.3280 USD = 132,800 USD. You have effectively sold 100,000 GBP and bought 132,800 USD.
  • If your broker requires 1% of 132,800 USD as margin, or 1,328.00 USD, and the GBP/USD falls to 1.3242/45, you are looking at a potential profit of:
    100,000 X (1.3280 – 1.3245 USD) = 350 USD

However, if the GBP/USD starts to rise and reaches 1.3300/03, you are looking at a potential loss of:
100,000 X (1.3280 – 1.3303) USD = 230 USD.

How do I manage risk when trading on margin?

The most widely used risk management tools in margin trading are the Limit (take profit) and the Stop-Loss orders. A Limit order can be used to lock in your profits if the market starts moving in a favourable direction: the trade will be automatically closed at your predetermined price. A Stop-Loss order, on the other hand, can be used to restrict your potential losses if the market starts moving against you: the trade will be automatically closed at your predetermined price.

In conclusion, we would like to remind you again that trading on margin carries a high level of risk and your account result depends solely on you. Regardless of the financial instruments you trade, be mindful of the techniques you can use to limit potential losses, such as using stop orders, for example.


Note: Views expressed here are for education purposes only and are not the views of Deltastock or its employees. These views are not personal recommendations or investment advice. Any quotes of financial instruments displayed on this page are indicative only and do not reflect the current market situation. You may wish to seek independent advice before entering into transactions.