Derivatives traders, including traders using financial spread betting accounts, contracts for difference, and futures, will typically make use of margin to trade with. This boils down to money loaned by your broker to help you maximise your profits. Spread bets and CFDs will be listed with their margin rates: for example, 1% for a forex trade, or 5% for an index trade. The percentage amount quoted is the amount of the actual trade you are covering with your own money. The rest comes from the broker.
The margin rate is largely dictated by liquidity – the ease with which that particular position can be traded in the market by your broker. Brokers reserve the right to change margin rates on products during periods of adverse market stress. This can sometimes be at very short notice indeed. A very illiquid stock – e.g. a mid-cap share – might have a margin as high as 50%.
In addition to the margin, you will be required to pay financing costs on your trade if you choose to roll it over to the next day. Many traders choose to settle their trades in the course of the trading day, but sometimes they will want to keep a trade open. Brokers will charge for their ‘loan’ to you if you keep it open between trading days. This is why it can be uneconomical to keep a spread bet or CFD trade open for too long. Traders making use of margin should pay particular attention to their broker’s terms and conditions as they affect financing.
Trading on margin also means that you are exposing yourself to more risk than trading physical assets like listed shares. This is because the bulk of your trade is being financed by your broker. On the upside, it means your trade, and your profits, will be larger. On the downside, it means your losses will be bigger.
A trade on GBP/USD at 1%, with £1,000 of your own money, will create a £100,000 forex trade. It is critical that you focus on the size of the trade rather than the margin in order to properly evaluate your risk. A 2% gain in this example trade would deliver £2000 (tax free if you are using a financial spread betting account). However, a similar swing to the downside would create a loss of £2000, wiping out the margin you posted with the broker.
Under the above circumstances, you would face a margin call. This is where the broker will ask you to post additional funds to keep your trade open. If you fail to do this, other trades may end up being closed to pay for it.
Don’t forget that many brokers will debit or credit your account in real time, as positions move in your favour or against you. It is important that you keep the liquid cash in your trading account sufficiently large to meet unexpected market swings. This is yet another reason why some traders like to close out all their positions before the end of the day.
One way of managing your risk is to use smaller positions, rather than taking a single large position. Another is to make sure you use stop losses or trailing stop losses to protect your trades from sudden swings in the price.