Let us imagine that the stock exchange is a huge market where people buy and sell shares of companies, currencies, and other securities. A margin is like a credit card which allows you to buy more goods (in our case, stocks or currencies) than you can afford at the moment.
Margin is the amount of funds a trader must have in their account as collateral in order to trade on credit. In other words, it is the minimum amount that a broker requires from a trader in case their trades go wrong.
Use the margin on the stock exchange to increase potential profits. If you have the opportunity to trade on credit, you can buy more shares and, accordingly, earn more money. However, this only works if the market goes in the right direction.
Margin allows traders to react to market changes quickly without waiting for their own funds to become available.
However, it is not that simple. There is a risk of losing all the money that you have in your account or becoming indebted to the brokerage company.
Below, we will tell you more about what margin trading means and what situations happen when you make trades with the use of margin.
Initial and minimum margin
Margin trading is a transaction in which investors do not use their own funds but credit funds (those borrowed from a broker). Such trades are called unsecured trades.
So, let us imagine that you have 10,000 rubles in your account and you want to buy shares of a particular company. Without margin, you can buy shares only for this amount. However, if the broker gives you a margin, say 1:10, you can buy shares for 100,000 rubles.
If the stock goes up, your profit will increase 10 times. However, if the stock drops, your losses will also increase 10 times, and you risk losing your 10,000 rubles very quickly.
Thus, margin is a tool that allows you to increase potential profits, although it also increases risks. You need to be very careful when using margin trading.
Brokers recalculate the margin every time a trader opens another position.
The margin can be initial or minimum. The initial margin on the stock exchange is the initial deposit, without which it is impossible to open a new trade. It is calculated in such a way that the asset price is multiplied by the risk rate.
The risk rate is the probability of changes in the price of a particular asset. It is clear that the higher the volatility of the rate is, the higher the risk rate of this asset will be.
Often, brokers provide the risk rate indicators for certain assets on their official websites. By the way, risk rates for short trades will always be higher than for long trades, but we will talk about them later.
Now let us find out what the minimum margin means. The minimum margin is the minimum collateral that is necessary to maintain an already open position. That is not for opening, but for maintaining.
Usually, the minimum margin of one trading instrument equals 1/2 of the initial margin.
If the value of your investment portfolio at some point falls below the initial margin, you will no longer be able to buy back some assets in an uncovered position, and you will not be allowed to open new trades.
Now let us talk about what a liquid portfolio is. It means the total value of currency and all liquid securities that are stored on your account with the broker.
If it happens that the price of your liquid portfolio at some point falls below the minimum margin, the broker may close some of your positions. It is important to do this so that the price of your liquid portfolio does not collapse to zero or below it. By the way, the broker chooses the positions to be closed independently.
Before closing trades, a broker must send you a notification asking you to replenish your account. This message is called a margin call.
Long trading
Long trading, or long positions, is probably the most popular type of trade on the stock market. The principle of this trade is quite simple. Novice investors most often start with this trading method.
Traders resort to long trading when they expect quotes to grow. The essence of long trading is as follows: you buy shares while they are relatively cheap and then sell them on the rise.
As long as investors hold the shares, they are said to hold a long position. When they sell them, investors are said to be closing the long position.
Profit in this case is the difference between the buy price and the sell price.
Here is an example. You have 50,000 rubles in your account, and you can borrow the same amount from your broker to buy 100,000 rubles worth of a company's securities.
You expect that these shares will soon rise. If, in a couple of days, the value of these shares increases by 20% (i.e., to 120,000 rubles), you can get a profit of 20,000 rubles (120,000–100,000).
However, you should take into account the broker's commissions and cash reimbursements for the use of borrowed funds. That is, if you take away the above-mentioned payments from these 20,000 rubles, the resulting figure will be your net profit.
Such a trade is called long because the investor has the right to hold such a position for quite a long time.
A long position is interesting to many people because it gives an opportunity to get profit even with long-term investments, for example, when the investor puts in money for a period of at least one year.
Historically, securities rise in the long term. In theory, the price of a single share of any company can grow in value indefinitely. This means that you do not have to worry about price movements in the short term.
Even if the securities have suddenly fallen, after several years they will still recover and, most likely, will rise even more. Then the investors will have a bigger profit.
Here is an example. So, you follow the shares of company X, and you are sure that they will grow in the coming months. Today, the shares of this company cost 100 rubles per unit. You decide to open a position and buy 100 shares at 100 rubles each. This will cost you 10,000 rubles.
A few months later, thanks to a successful advertising campaign or good quarterly reports, the price of X’s share rises to 150 rubles. You decide to close your position and sell the securities. By selling 100 shares for 150 rubles, you get 15,000 rubles. Your profit is 5,000 rubles (15,000–10,000).
Thus, by trading long, you bet that the price of the asset will rise. If your forecast comes true, you earn on the price difference. However, you should always keep in mind that the market may move in the opposite direction, in which case your losses will be very significant.
Short trading
Traders open short positions when they intend to profit from a fall in an asset price.
It looks like this: you borrow securities from a broker, then sell them, and wait for a price decrease. Then, you need to buy the same number of shares, but at a lower price, and return them to the broker.
This difference between the sell price and the buy price will be your profit.
You can open a short position only for a short period of time, and this is what distinguishes it from a long position. The term of the position should be short because you need to return the shares that the broker lent you for money.
A short order is not selling securities from your investment portfolio. If you sell shares you bought earlier, you are merely closing a long position.
Short orders (like long ones) are opened, held, and closed. If you decide to open positions, expecting a decline, you will be said to be shorting.
If it happens that you did not manage to buy back the securities and could not close the open position in time, you will be said to be in a short position or shorts.
Now let us focus on an illustrative example. So, you expect that the share price of a company is about to fall by 20%. With this expectation, you borrow the security of this company from a broker. Then, you sell it at its current price, for example, $100 per unit. Once the order is executed, $100 appears in your account.
In cases when the share price falls by 20%, you buy it at $80. Then, you have to return the stock to the broker from whom you borrowed it. After that, $20 will remain in your account, and this will be your profit.
However, traders should keep in mind that potential losses in margin trading could be both small and substantial. Huge losses are often suffered in case of short margin trading.
The amount of losses may be even greater than the amount that is displayed on your brokerage account at the moment. Traders will have to bear all these losses themselves; there will be no compensation from the state or a brokerage company.
Example. Let us imagine that the shares of company Y, according to your calculations, should soon fall in price. Now, they cost 200 rubles per unit.
You decide to open a short position. To do this, you borrow 100 shares from a broker and immediately sell them on the market at the current price of 200 rubles per share. This is how you receive 20,000 rubles in your account.
Some time later, due to bad news or poor financial results, the price of share Y falls to 150 rubles. Now that your forecast has come true, you decide to close your short position. You buy 100 shares on the market at 150 rubles per share but spend 15,000 rubles. You return these shares to the broker, closing your debt. Your profit amounts to 5,000 rubles (20,000–15,000).
Thus, short trading allowed you to make money on the market decline. However, the risks are also great: if the share price rises instead of falling, the losses could be noticeable.
Short positions pose more risks than long ones
If you are a novice investor, you should not fully rely on margin trading, as this strategy is the riskiest.
The main risk is that the price of a stock may soar against all market expectations. If this happens, you will instantly find yourself in a very difficult situation. You will have to give the broker all the shares you borrowed from it. What is more, before that, you will have to buy them at a much higher price than you sold them.
If you still intend to try to make money on short selling, you should insure yourself.
Stock market experts recommend placing stop-losses and not borrowing too much.
When trading on margin, both you and a broker are at risk. That is why many of them have certain restrictions for those who want to make a profit on falling stocks.
For example, you will only be able to open short positions on stocks that are considered the most liquid on the market. The broker usually publishes a full list of such stocks on its official website.
In addition, brokerage companies determine the amount that must be in your account before you start opening a short position.
This amount is usually higher than the total value of all borrowed securities. This rule is necessary because you have to cover the cost of borrowed shares when their price suddenly rises instead of falling.
In this scenario, the brokerage company also sets a certain price, after which you (or the broker itself) can close the position. This happens when the funds you have pledged are not enough to buy back the shares.
Stock market manipulators are engaged in short selling. As a rule, these are big investors who have enough money to set the market dynamics they need.
Actually, for this reason, special commissions closely monitor the market situation. For example, in the United States, it is the SEC (Securities and Exchange Commission), and in Russia, it is the Central Bank.
How short and long positions influence market
If you mainly open long positions, you are called a bull. Indeed, when the number of those who are confident in the further growth in the stock price becomes really large, the market starts to move up.
The same principle works in relation to the strategy that is based on opening short positions. If you are a fan of this type of trading, you are called a bear. If, at some point, the market is dominated by bears, it starts to fall.
However, the opposite may also happen. For example, at some point, the market has accumulated significantly more long positions. If investors start to sell their securities en masse, i.e., close their positions, it will lead to a collapse in quotes.
The same thing will happen with short positions. Thus, a large number of such positions will lead to the fact that any news will entail mass purchases of shares. In this case, quotes may skyrocket.
Pros and cons of margin trading
Margin trading has both advantages and disadvantages.
The pros include an impressive size of a possible profit. You can really make a substantial profit with the help of borrowed funds. However, this will become possible only if your predictions meet reality.
Margin trading gives you a unique opportunity to conduct trading operations for an amount that significantly exceeds your account balance.
However, if your forecasts fail to come true, you may suffer considerable losses and lose the funds that you do not actually possess.
This is perhaps the main disadvantage of margin trading.
One more disadvantage is that the brokerage company cannot provide you with an opportunity to open short positions on all trading assets.
Also, when trading on margin, you have to pay a commission for the rollover of the held position even on non-working days on the stock exchange.
What is more, if the price of the liquid portfolio decreases below the minimum margin, a broker may close your positions.
Let us explain all of the above-mentioned issues using examples.
We are going to illustrate an ordinary transaction. You had 100,000 rubles in your account. You bought shares of one company with this money, hoping for their further growth. However, your expectations did not come true, and the shares fell by 20%. As a result, you lost 20,000 rubles, and your portfolio is now valued at 80,000 rubles (100,000–20,000).
In case of margin trading, things will look a bit different. You have 100,000 rubles in your account. As in the first case, you are counting on the growth in the shares of the same company. However, you want to use margin. A broker gives you 100,000 rubles. After that, you have 200,000 rubles in your account, and you invest them in shares.
However, the price of these shares collapses by 20%, making you lose not just 20,000 rubles, as in the example above, but 40,000. This happens as the borrowed money should be returned to the brokerage company. As there is no compensation, you will have to pay the needed sum. As a result, your investment portfolio will be valued not at 80,000 rubles but at 60,000 (100,000–40,000).
It is important to remember that even if the price of the shares you bought changes insignificantly in an undesirable direction, the amount of possible losses may be much higher than the amount of funds you have in your account. Keeping this in mind, you should weigh all the pros and cons of trading on the stock exchange.
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