Is trading on margin a risky investment?
All forms of investment carry risk, but trading on margin is a concept that many people believe leaves you particularly exposed to potential losses. But is this reputation deserved? And if so, what makes trading on margin different from traditional trades?
In this article, we take a look at the basic premise of trading on margin, and examine its risk, relative to standard investments.
What is trading on margin?
Before we dive into the risk involved, let’s first make sure that we understand what trading on margin actually means.
Margin is the amount of money you need in your trading account to open a position. The margin acts like a deposit intended to cover the most you might lose on your position. It is taken from your account when you open a position and returned when the trade is closed, minus any losses.
The benefit of investing on margin is that you create leverage, in that you can control a larger investment with a relatively small amount of capital. This means you can access markets for a fraction of the cost, and increase the number of trades controlled by your investment capital.
CFDs are an example of an investment vehicle that makes use of the benefits of margin and leverage. Trading CFDs allows you to speculate on the price movement of a certain asset without actually owning it outright.
What’s the risk of trading on margin?
But margin and leverage is a double-edged sword. Using higher levels of leverage may boost your potential purchasing power, but it also increases your exposure to risk. You’re essentially trading assets with a value greater than the purchase price, so all fluctuations will be magnified. Say you’re trading shares: if the share price drops, going against your position, it will have a greater negative impact on your investment than would the decrease suffered by shares purchased the traditional way.
The other risk is that your margin doesn’t represent the most you can lose on your position. You are exposed to potential losses that exceed your investment if a position goes badly against you.
In short, trading on margin and leverage does not make a profit or loss any more or less likely – it simply magnifies the outcome either way.
Protecting yourself from risk
Due to this magnified risk-reward, it’s wise to borrow only what you can afford to lose. Many novice investors underestimate the exposure created by trading on margin, and can be surprised by the amount lost in a trade gone bad. It’s therefore crucial to calculate your margin so you understand the risk of any given trade, and to keep in mind that you can lose more than your initial margin payment.
You can use stop-loss orders to protect yourself from this downside risk. This instructs your broker to close your position automatically should your market hit a certain price. For example, if you purchase a share at £50, you could place a stop-loss order to sell should the price drop to £47. Doing this will help limit the loss from a trade, but you should note that stop-loss orders are not guaranteed and can be subject to market gaps and slippage.
You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.