How to trade on margin?
Margin trading is the ability to transact in foreign currencies, securities, other financial assets and derivatives with borrowed funds. In order to conclude a transaction, a broker lends the trader money at a certain interest rate and against a pledge, which gives the investor an opportunity to acquire more assets than when using only his own funds. How to trade on margin?
The concept of margin and its types
Margin is a trader’s own funds, which a broker fixes as a pledge for providing credit. Whenever an investor opens a new position, the margin is recalculated again. It is also recalculated in case of changes in the value of existing assets. Thus, on the trader’s deposit, there is always a pledge, which is a sort of the insurance deposit to the brokerage company. With this deposit, the broker protects himself from non-payment of credit.
There are two types of margin:
- Initial, which is calculated for a new transaction. To calculate the initial margin, the cost of the purchased asset must be multiplied by a special risk rate, i.e. the probability of price change. The risk rate may vary for different currency pairs or stocks. Usually this rate is higher for assets with high volatility.
- The minimum, which is calculated to support the already open positions. At most brokers its value is equal to half of the initial margin amount.
Margin is calculated not only for each asset separately, but also for the entire liquid portfolio as a whole. A liquid portfolio includes the value of currency held on deposit and assets that have high liquidity. The value of liquid stocks, bonds and other assets is calculated according to the currently set exchange rate published on the stock exchange.
If the value of the liquid portfolio is below the initial margin, the investor will not be able to open new positions. And if the portfolio becomes less than the minimum margin level, the broker will send a special warning to the trader – a margin call.
What is a margin call?
It is a message from a brokerage company informing a trader that there are not enough funds on the deposit to use leverage for new trades and to maintain the current margin position. After receiving a margin call, an investor may act in one of three ways:
- Deposit a sufficient amount that will provide open trades.
- Close a portion of positions independently, selling assets at the current market price.
- Trying to wait for favorable changes in the market.
But in case of choosing the latter variant one should take into consideration that if the trader does nothing for some time and the situation on the stock market does not change to the better, the broker will simply close positions automatically – sell shares, bonds, currency even at a loss for the investor.