Do you understand the margin trading risk you’re taking?

 

Accessing the markets has never been easier. And in the last year, loads of new traders have jumped in.

Apps put hundreds of stocks, indices, commodities and forex pairs into our pockets, and we can access buying, selling and betting on outcomes at the touch of a button.

There’s also been a ‘gamification’ of trading, with apps like Robinhood showering your screen with confetti and giving away ‘free stock’ to new users. It feels like it’s only a baby step away from the computer games my teenagers are playing online.

I’ll be honest – I love how easy it is. It’s great being able to access my account from anywhere and to take advantage of low trading costs.

And I also love that trading the markets has become accessible – it’s no longer the domain of a wealthy few. Anyone can do it, and we can all get the benefits of investing, even if we don’t have a huge fund behind us.

But, of course, there’s a flipside – people accessing the markets without understanding the risks they are taking.

A tragic story that came out of lockdown in the summer was of a 20-year-old in the States who committed suicide after believing he was $750k in debt when looking at his online account balance.

In a note left for his family, Kearns said he had ‘no clue about what I was doing” and never intended to “take this much risk”.

The horrific irony of it is that Kearns was probably trading options spreads, and wasn’t in anything like this kind of debit. It seems likely that he mistook a potential loss on one leg of his options as the outcome for the overall bet. It’s not clear exactly what his trading activity was, but it is clear that he didn’t fully understand what he was doing.

I’ve had a few queries recently about leverage and margin trading risk, and I want to ensure every Trader’s Bulletin member does know what they’re doing.

That you never find yourself out of your depth in the markets.

There have been times in my trading career when I’ve given myself a very uncomfortable shock … when losses have built up … or I’ve made an error when placing a trade … or allowed a trade to run away from me ….

But these have, in the end, been learning experiences, and have never been catastrophic.

(I’m going to look at spread-betting here, and won’t cover options trading – it’s a different beast. If you’re interested in options trading, do get in touch as I have some recommendations in this area.)

There were some big changes to margin requirements made in back in 2018 Europe (which still apply post-Brexit). These were designed to make trading safer.

Margin requirements were increased by as much as ten-fold in some markets.

At the time, it felt like a shock and an imposition, but what I’ve seen over the past couple of years is that we’ve been forced to take more measured position sizes.

So, let’s take a look at exactly what margin is, what margin trading risk is, and what both mean within your account.

When you take out any spread-bet position, you are putting your money at risk. There’s no way to trade without taking any risks.

The risk on a spread-bet position is measured by the size of your stake, and the distance to the stop level on that trade.

So if you trade GBPUSD with a stake of £2, and your stop distance is 50 pips away from your entry, your risk on that trade is £100.

On a trade ticket, this may look something like this …

So, you’ve limited your trading risk on this position to £100.

But what about slippage?

There are instances when a trade like this could lose you more than £100. If the market drops very quickly, your broker may not be able to get you out of this position at the price you’ve requested (1.32519). This means you’ll be taken out at worse price, and your loss could be bigger.

If you’re trading large, liquid markets, this tends not to be a big problem, but you may suffer a few points of slippage here and there.

A ‘guaranteed stop’ is away to avoid this – but there’s a cost involved. As you can see on the ticket above, you can tick the ‘Guarantee’ box and pay the £6 charge for this privilege. This means you’re guaranteed to get out at the price you asked for, with no slippage. (If slippage occurs, your broker will take the cost of it.)

And what about that £886?

Look again at that trade ticket, and you’ll see the estimated margin cost at the bottom of £886

That’s significantly more than our trading risk level – so, what does it mean?

Margin is about the cost of the underlying position that we’re betting on with our broker. In theory, your broker might have to ‘offset’ your position by buying £2 x 13301 of GBPUSD. That would ensure they are able to pay out if your trade wins.

That could potentially cost your broker £26,602.

But, of course, your broker doesn’t do this every time you place a trade.

Instead, they should be carefully balancing their book according to all the different trades clients place, and where there are significant differences, they will lay off that risk on the market.

And what the current laws require is that your margin requirement to open that position is 3.33% (for major FX) of the size of that position.

So, 3.33% of £26,602 = £886 margin requirement

Having this margin requirement can be a frustration when we want to open multiple positions, we know our trading risk is carefully managed … and the broker blows a raspberry and won’t let us do it.

However, I have seen this requirement affect the way people trade, and I believe it is for the better.

Because margin is calculated on the scale of the instrument you’re trading, naturally margin requirements will be greater on larger instruments.

While it’s not always the case that a bigger instrument moves more … it often is the case.

This naturally steers traders to more cautious position sizes (and sometimes also to wider stop distances/profit targets) on these bigger markets.

In fact, that’s the case across all markets – smaller stakes will mean much reduced margin requirements. Trading styles which take a more long-term view, with wide stops and targets, and low stakes, are ideal for keeping margin low.

But that doesn’t mean other trading styles must get thrown out

I expect you’ll know that I’m a big fan of the benefits of holding positions for days, even weeks. It tends to bring in the most consistent profits for the smallest effort – a win-win!

But I also day trade – it’s an important part of my investments.

Short-term positions, by their nature, tend to have tight stops and large stakes.

Let’s say that I want to risk £100 on a trade on GBPUSD with a stop of just 10 pips. My stake would be £10

Translate that into an instrument size for GBPUSD of 13301, and the market requirement at 3.33% is …

(£10 x 13301) x 3.33% = £4,429

My risk is exactly the same as that first trade we looked at, with the 50 pip stop, but I’m now required to have £4,429 in my account just to open this.

It feels steep … but really, to be taking a risk of £100/trade, we should have a bank of around £5,000. What this does is it can restrict us from opening multiple positions at the same time. However, these are short-term trades, so will soon be over, and we can free up that margin to invest on the next opportunity.

Tighter margin requirements have nudged me to be more discerning in my trade selection – rather than scatter my position across instruments, I’ll hunt down the best set-ups and focus on these. And trading less, but trading smarter has a positive impact on our bottom line.

If you want to find out more about margin, please take a look at my FREE margined trading course.

 

 

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