If you thought trading with your own money was a risk, then trading with other peoples is nothing short of stupidity. For the new trader this is like passing your driving test, and immediately taking the wheel of a sports car. Press the pedal and you will be rocketed forward, probably straight into a brick wall, and then the hospital.
Imagine for a moment that you have gone to the casino with friends, but unfortunately you only have £50 in your wallet. Your friend kindly offers to lend you another £50 for the evening. Full of confidence you advance to the tables and promptly lose the lot! In the space of a few minutes you have not only lost your own money but also your friend's. Had you just lost your own money you would have lost 100% (£50/£50). You have managed to lose 200% (£100/£50). This is what trading on margin is all about. It is called leverage and both losses and gains are magnified enormously.
In essence, trading on margin is borrowing money from your broker to buy shares and use your investments as collateral. Unfortunately margin exposes you to substantially higher risks and much bigger losses. You might ask why I am telling you all about it if it is so risky. The answer is twofold. First, I want you to understand the risks involved, and that it is NOT for the novice investor. Secondly, there are several instruments and markets that you can ONLY trade on margin. One of these is spread betting. Two others are options and currency. In the currency market which I know very well, as I trade it every day, some currency brokers offer leverage of 400:1. In other words for every £1 in your account you are able to trade 400 times that amount.
Let us suppose you bought a share at £10 and the price rises to £15. If you bought the share in a cash trading account (ie with just your own capital) you would earn a return of 50% ( £5 /£10). Now in a margin account your broker can lend up to 50% of the amount you deposit in the account. So suppose now you had bought this share using a margin trading account. You would have put in £5 and the broker would have lent you £5 to buy the share initially. It has now gone to £15. You pay back the broker the £5 he lent you, and you have been left with £10. Your profit is £5, a 100% return on your money!! ( £5/£5). So for a 50% increase in price, you have made a 100% return. Now let us look at the down side of trading on margin. Suppose the share you bought on margin at £10 falls to £5 - you pay your broker back the £5 you borrowed, and you are left with nothing. So on a 50% fall in value you have lost 100% of your capital!!!
This is what is called leverage. Leverage is a double edged sword, which amplifies both losses and gains to the same degree. Because leverage magnifies everything, it hugely increases the risk in your portfolio. In addition to the above there are two other factors to consider. Firstly there is interest to pay, as your broker does not lend you money for free. Secondly there is the dreaded margin call. If your margin account falls below very prescribed limits you will receive a margin call - this is the broker asking for more money to cover your losses. If this is not available immediately, your broker has the right to close some or all of your positions in order to reduce your exposure to the market. This is likely to happen in particularly volatile markets. If you receive a margin call, in my opinion, you are out of control.
If you are new to investing, I strongly recommend that you stay away from margin trading as long as possible. When and if you feel ready, remember you do not have to use the full 50%, you can start at a lower rate, so consider starting at 10% - you should still be able to sleep at night!
Author: Anna Coulling
http://www.making-bread.co.uk/
