One of the most common concepts in Forex, cryptocurrency markets, commodity and stock exchanges, is margin trading. The concept that many confuse with credit, because they are really similar. However, these are different things. We talk about margin trading and its features.
Margin trading is a financial transaction for which funds are provided by a broker against a client's pledge (margin).
The main difference between margin and loan is the actual amount of money provided. It is many times larger than the margin itself. The size of the margin is agreed in advance, as a rule, it represents the difference between the price of the asset and the profit from it. The guarantee does not have to be cash, it can also be any valuable assets.
The principle of margin trading
Margin trading is closely related to leverage. It arose because of a very commonplace - not every novice trader owns the necessary amount in order to start trading. The trader turns to the broker and he allocates funds to him, taking back a deposit and a certain loan rate. A trader and a broker establish the so-called minimum margin - that is the bottom line on the trader’s balance sheet, upon reaching which, his position will be closed to prevent further loss of money. Also, the position will be closed if the broker does not respond on time to the “margin call” - a signal from the broker that he needs additional funds in the margin loan. This usually happens when losses reach half the available margin.
It should be noted that brokers have the right to close positions even against the wishes of the traders themselves. Also, this is a right for financial agents whose job is to monitor the trader’s accounts and prevent the balance from reaching the established minimum margin. As for the collateral, it will be automatically returned only after the successful implementation of the position.
With margin trading, a trader can open both short and long positions, that is, sell or buy assets. And while the position remains open, its assets provide a loan. If he begins to lose money, his losing position closes, and all of his accumulated assets are completely transferred to the status of loss coverage.
The size of the loan and allocated funds is negotiated directly with the broker. Not every trader can get a big leverage by starting Forex trading. It depends on the broker, but it also depends on the trader. Each of them is assigned a so-called risk level, according to which traders are divided into several types:
• Client with a standard risk level - insignificant margin loans are provided.
• Client with a high level of risk - large margin loans are provided.
• Client with a special level of risk - loans are provided only to legal entities.
The logic here is simple: the larger the loan, the greater the risk, and the greater the potential profit from client transactions.
In cryptocurrency trading, the risk of margin trading is even greater than anywhere else. The reason here is the high volatility of cryptocurrencies as such.
There is also such a financial instrument as “margin financing”. It indicates the possibility for other traders to direct their own finances to support the margin transactions of a particular trader, that is, to act as a kind of third party. They also get the opportunity to liquidate their positions in order to avoid big losses, therefore their risks cannot be called excessive. Naturally, margin financing is not a free service. An agreement on the payment of a certain interest rate is concluded between traders.
Pros and cons
Like other financial transactions, margin trading has its pros and cons.
• Increase profits. The most obvious plus. By increasing the value of positions in the trade, the trader can make a big profit.
• Reducing risks. Since traders can always take advantage of margin trading and immediately open several positions for investments at the start, this helps to avoid many risky situations.
• Quick opening of positions without mandatory transfers of significant assets.
• You can earn even by declining asset prices.
• Increase in losses. The principle here is exactly the same as with profit. As you know, one of the rules of the market is: the higher the profit, the higher the risk. Margin trading is fully applicable. Even insignificant changes in the market can lead to bankruptcy.
• Payment of commission for the provision of funds.