What is margin in trading — how does it work?

Margin trading is the ability for traders to open a much bigger position through leverage with only a small amount of investment capital. The margin will be set as a percentage of the overall value of a position from the asset you might want to trade following the leverage ratio you choose to use.

In margin trading, you essentially ‘borrow’ money from your broker to leverage the position you want to open and get exposure to the entire value of the position. The margin can be seen as a security deposit for the money the broker borrows you.

For example, in traditional trading, if you decide to buy 10 Google shares at $200 a share, you’d have to invest $2,000. However, trading on margin with a 10% margin rate, you’d only need to invest $200 while still getting exposure to the entire trade value.

Remembering that margin trading can only be done through derivative products such as CFDs or spread betting might be essential.

Margin trading works by depositing a small amount of investment capital to gain a bigger exposure to the market through leverage. This allows you to open bigger-size trades with only a fraction of the amount.

The required margin needed to open a position will generally be presented as a percentage, whereas leverage will be a ratio. For example, if you are trading with a margin percentage of 10%, that means you’ll have a leverage ratio of 10:1.

This means that for every $1 you invest, your broker will ‘borrow’ you $10.

Now, the margin requirement percentage will differ depending on your broker, the financial instrument you might want to trade, your position size, your leverage ratio, and the market volatility.

When trading on margin, your profits and losses will be magnified because each trade’s results will be determined by the entire value of the position, not just your margin deposit. That said, losing the entire margin deposit is possible if the trade goes against you.

So, it might be necessary to deposit more funds from the start, also known as maintenance margin, to ensure the position stays open if the trade starts going against you; otherwise, your broker will send out a margin call notification.

Once you close a trade, the money you borrowed from your broker will be returned to the broker, and you will either receive the profits gained or have to deal with the losses.

Now that you’ve got a better understanding of what margin is and how it works, let’s tie everything together and go over two examples: one for buying on margin and one for selling on margin.

Buying on margin

Let’s say you are looking to buy ten shares of Apple at a share price of $300 per share; this will give you a total value of $3,000. Now, with margin, you won’t need to invest the entire $3,000. 

Instead, you’ll only need to invest a certain percentage of that amount to open the position.

If your chosen broker requires a 10% margin requirement to open this trade on Apple, then you’d only need $300. This also gives you a leverage ratio of 10:1.

If you deposited $1,000 into your account, you still have $700 remaining, which can be used to open another trade or as a maintenance margin to keep the trade open if it moves against you.

Selling on margin

Selling on margin works the same as buying on margin. However, in this instance, you predict the price of an asset will fall and try to profit from that.

Since trading on margin is done through derivative products, trading both rising and falling markets is possible. This is because you’re only speculating on the price movements without taking ownership of an asset.

Now, let’s take Apple again, but in this case, you’re looking to sell ten shares at $300 per share. Similarly, you’ll only need $300 to open the trade with a 10% margin requirement at a leverage ratio of 10:1.

However, in this instance, you’ll profit if the price of Apple shares declines.

Now, in both cases, whether buying or selling on margin, it might be important to remember that both profits and losses are calculated based on the $3,000 and not your margin of $300. This is why having a good risk management strategy could assist you in limiting any potential losses that could occur.

There are a few components within margin trading that might be beneficial for every trader to know. Below, you’ll find a detailed description to better understand what these components are and what they mean.

Initial margin

Initial margin refers to the amount you’ll need in your account to open a position calculated from the margin percentage. Sometimes, you’ll find that it’s called deposit margin.

Free margin

Free margin refers to the funds available to open new trades, but it can also refer to the funds available after a position has already been opened. These funds, which are available after a trade has already been opened, can be used to open a new trade or maintain the margin of the current trade if the position does happen to go against you.

Maintenance margin

The maintenance margin is the amount required to keep the position open if the trade goes against you. You will encounter a margin call once the maintenance margin falls below a certain level due to consecutive losses to your account.

Margin call

A margin call is a notification sent out by your broker indicating that your maintenance margin has fallen below the required level and that more funds must be added to your account to keep the trade/s open.

If you fail to meet these requirements, the broker can go forth and choose which open trades they want to close automatically at the current market price, regardless of which trades might be profitable. You’ll unfortunately have to deal with any losses obtained.

The reason for a margin call is to prevent your account balance from falling to zero.

Margin trading is a popular form of trading for many traders and comes with its own set of benefits. Let’s have a closer look at what some of those benefits are.

• Margin trading allows for the use of leverage, which allows you to control a bigger position with only a small amount of investment capital. This means you could diversify your portfolio across many financial markets, such as forex, commodities, shares, indices, and more.
• When trading on margin through leverage, your profits will be magnified because the end result of the trade will be calculated based on the entire position value, not just your initial margin amount.
• Margin trading is done through derivative products, which means you can trade both rising and falling markets.
• Unlike regular types of loans, when borrowing funds from your broker, there is no set time to repay those funds. Instead, once the trade is closed, the borrowed funds will go back to the broker, leaving you with the profits gained.

We saw that trading on margin does yield some benefits. However, there are also risks involved when trading on margin. Let’s have a look at some of the risks concerning margin trading.

• Now, we see that the funds you borrow from the broker will be returned, and you’ll be left with the profits; however, if your account makes a loss, you’ll have to deal with those losses.
• Another factor you might want to consider is the interest rates payable upon your broker’s loans. Every broker has their own interest rate regarding borrowed funds to trade on margin; these rates can vary from 4.75% up to 12% per trade.
• Using leverage to trade on margin can magnify your profits, as we saw in the previous section. However, it can also magnify your losses. And if risk management isn’t properly applied, it also has the potential to wipe out the funds in your account.
• Your broker could send a margin call notification when your maintenance margin falls below the required level to keep any trades that might’ve gone against you open. This notification states that more funds need to be added to your account. If this is not corrected, the broker can choose which of your open trades they want to close, regardless of whether it’s in profit or not.

Margin and leverage go hand-in-hand because you’re utilising leverage with your trades to trade on margin. By trading on margin through leverage, you can open a position worth more than the funds you have to put down.

What this means is you get a bigger exposure to the market with only a small amount of capital that needs to be invested, which is called margin.

As mentioned before, margin is presented in the form of a percentage and leverage in the form of a ratio. With a margin requirement of 10%, you’ll have a leverage ratio of 10:1. This means if you want to open a position worth $10,000, you’ll only need to deposit 10% of that amount.

Now, with a leverage ratio of 10:1, it refers to every $1 you deposit, your broker will ‘borrow’ you $10. Let’s use the above-mentioned amount again; with a position worth $10,000, you deposit 10%, which is $1,000, and the broker will ‘borrow’ you the remaining $9,000.

This works the same if you have a margin requirement of 5% with a leverage ratio of 20:1.

For a position worth $10,000 at a 5% margin, you’ll need to deposit $500, and the broker will ‘borrow’ you the remaining $9,500 to open the position.

Once the trade is closed, the borrowed funds will be returned to the broker, and you’ll either receive the profits gained or have to deal with any losses.

Margin trading can potentially provide you with profits but also comes with significant risk. As mentioned, your profits and losses are magnified when trading on margin through leverage. 

This means you can gain greater profits with only a small amount of funds, but on the other hand, there is also the possibility of having all of the funds in your account wiped out if a trade goes against you. 

It might be best for novice traders to start with a cash account and learn how the market works before moving on to margin trading. However, if you decide to participate in margin trading, it might be best to start with a small amount of funds you could afford to lose while learning how the market works.

Another factor to remember might be to have a solid trading plan and risk management strategy in place, as some financial markets are more volatile than others.

Ultimately, deciding if margin trading is suitable for you is a personal choice that coincides with your trading and investment goals.