What is margin?

A lot of traders got a hard lesson about margin last weekend – I hope you weren’t one of them.

If you trade with IG Index, who I use for some of my trading, they quadrupled their margin on the Dax last weekend.

And they’ll be doing it again this weekend (how much they increase margin will vary from instrument to instrument) …

To avoid having my trades closed down due to lack of margin over the weekend, I had to load my account with a lot more money.

If I hadn’t had the capital to hand, I’d have been forced to close down losing positions – I wonder how much of the reasoning behind the increase was to force traders into doing just that.

Many traders ignore the margin requirements on their trades, opting for one of the following scenarios …

… leaving far too much capital sitting in their spread-bet accounts, to help fund their brokers’ Christmas bonus.

… or leaving their margin requirements so tight that they risk getting cut off.

So, the benefits of keeping one eye on your margin requirements are two-fold: you reduce the risk of getting a call; AND you can use your money better.

But what IS margin?

Over recent years, margin has got itself a bad name, as people have used it to over-leverage themselves. In simplest terms, it’s the use of debt to increase profits – borrowing money to invest it.

Back in 2007, Lehman Brothers were working on a leverage of 44 to 1.

We’re not going to use margin to over-extend ourselves, but instead we can use it to make our money work hard for us.

As spread betters, we use margin all the time – that’s how spread betting functions.

Margin is used in many walks of life – in a good way, and in bad ways. Here are a couple of examples …

A • I’ve had a great tip on a horse running in the 3.10 at Lingfield, with odds of 20/1. I’m going to put all my money on it, but I’ve only got £100 in the bank, and I need to make more than £2,000 (I’ve got some loan sharks on my back from the last time I did this). So, I ask friends and family to lend me £100 each. I show each of them my £100 to prove that I’ll be able to pay them back. I persuade 9 gullible friends to give me the money, so now I’m off to the racetrack with £1,000 in my pocket, hoping to win £20,000. I’m 10 times leveraged. And my friends have only asked to see a margin of £100 before giving me this leverage.

B • Another example of leveraging is when we buy a house. My bank asks me for a 5% deposit, so I’m leveraged 20x for this transaction. With a 10% deposit, I’d be geared 10x in the investment. And if I took a deal with a 0% deposit, any downward move in house prices would land me in negative equity.

I hope this demonstrates that margin can be useful – when used wisely. But, if used blindly can get us into all kinds of trouble.

Margin and your trades

So, how does margin work in the world of spread betting?

Let’s say that I want to invest in the FTSE.

Its current price is 6,471.

But I’m not going to spend £6,471 to get in on this.

I’m going to place a bet of £1/point.

My broker asks for 0.5% margin, so I have to deposit £32 in order to open this trade. (£6471 x 0.5%)

If the value of the FTSE falls to zero, I could be in serious trouble. The actual value of my position is £6,471, but I’ve only been asked to stump up £33. Sounds scary!

This is why we’ll always trade with a stop loss AND we’ll always have enough money in our account to cope if the market moves against us (I’ll explain this in a moment when I get to ‘variation margin’.)

If the market moves against you and you don’t have enough money in your account to cover it – that’s when you’ll get the dreaded margin call. If your account isn’t topped up – the trade will be closed down.

Margin and your broker

Different spread-bet firms calculate their margin requirements – don’t expect it to be the same across different platforms. Some will reduce the margin required if you tighten up your stop loss. And some will automatically place a 10% stop on your trade when you open it.

Margin also varies enormously from one instrument to another, depending on the stability and volatility of that instrument. The FTSE, for example, will have a very low margin requirement. However, if you look at small-cap shares, you could be asked to deposit a 20% margin.

What happens when your trade loses money?

Okay, so we’ve got the idea that we’ll need to deposit a certain percentage of our position with our broker. And we’ll use a stop loss to stop our market exposure getting out of hand.

However, if our trade moves into the red, then that deposit we’ve made gets eaten into by losses.

Let’s go back to that FTSE trade …

Let’s say that the value of the FTSE has fallen by 20 points since I placed that trade.

I’m now sitting on a loss of £20 on that trade. This is going to be taken away from my available funds, so my deposit now needs to be £32 + £20.

While I wouldn’t expect anyone to be trading with just £32 in their account, it’s really important to be aware of how much you need to cover your positions – i.e. your margin requirements PLUS enough to cover your trade moving into the red before it comes good.

It also helps us to guard against having too much in our trading accounts.

Let’s say that this FTSE trade had a stop level 70 points below the entry, so my maximum risk on this trade was £70. And I’m risking 2% of my fund on this trade. So my trading fund should be £3,500.

My broker would love me to load that £3,500 into my account.

But why should I?

My margin requirement on the trade is £32 … if it moves 70 points into the red, then my deposit only needs to be a little over £100.

I’m not suggesting that you play it this close to the wire with your margin requirements. Most of us don’t want the hassle of topping our accounts or filtering off funds after every trade. And, as we saw last weekend, brokers can suddenly increase their margin requirements, and we need to have some spare in the account to cover our trading.

But take a look at the trading you do, and what kind of margin you’re using, and you should quickly get an idea of what’s a sensible figure to keep your account ticking over.

The rest of your trading fund can, meanwhile, be working for you – either in other investments, or offsetting your mortgage, or at the very least sitting in YOUR bank account rather than your broker’s.

 

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