What Is Margin?
The term "margin" in investing and finance has varying definitions depending on the area and context in which it is used. In commerce, margin (or sales margin) can refer to the difference between the basic cost paid for products being sold and their sales price to the end consumer. The costs calculated only include direct costs of the product and not other costs related to operation of the business that is selling them. In this case, margin is often described as a percentage of the final sales price.
Another related definition of margin, also known as profit margin, appears in business accounting. This definition takes into account a company's profit in relation to full costs of business. It's frequently used in reference to formal business income statements and can be determined in relation to the company's operating costs, gross income or net income.
The concept of margin for commerce and financial reporting deals with profits made after sales. However, the concept of margin for trading in capital markets is related to investment capital that is available to traders before they carry out trades of securities and other assets.
Generally, when traders enter types of trading that expose them to losses of more than their stated available investment capital, their broker will require them to open a margin account. A margin account holds a deposit of funds that acts as collateral and can be withdrawn to cover for possible losses in case an investor's trading does not go as planned and results in a negative investment account balance.
If a trader's activities do result in a negative balance they will receive notification from their broker, known as a "margin call." They will then be required to increase the funds in their margin account to cover the money they may owe in the market.
Traders holding margin accounts are often granted a special privilege from their brokers known as leverage. In a basic sense, leverage occurs when traders borrow money to invest and try to receive a greater return than would be possible if they only used their own available capital. In this case, a broker will extend additional trading funds to a trader's account based on the amount of assets held in the account.
Leverage offered is typically expressed in terms of ratios and will vary on the type of asset being traded. Depending on the broker, traders may be extended leverage anywhere from two times the trading in their account (2-to-1) to ten times (10-to-1) or more of their account. currency trading The maximum amount of leverage allowed in forex trading in the U.S. is 50-to-1, while some dealers outside of the U.S. may offer leverage of 400-to-1.
Risks And Rewards
Trading with leverage on margin accounts can help traders gain much more than they could normally with their own resources. For example, a trade worth US$5,000, at 10-to-1 leverage, would be multiplied 10 times to be worth US$50,000, and the corresponding profits from the trade would also be multiplied by a factor of 10. While leverage offers a unique opportunity for profits, it can also multiply risk by a similar amount.
For example: if a trader's losses on a particular unleveraged trade are US$200, at 10-to-1 leverage they could be multiplied to cost the trader US$2,000. Thus, traders are usually encouraged to use leverage conservatively and consider the potential losses alongside the profits possible on a highly leveraged trade.
Interest On Margin
Effectively, leverage on a margin account is a loan of funds from a broker to the trader. As a loan, brokerages dealing with certain types of assets can charge interest on funds extended beyond the trader's basic margin deposit. The interest is usually charged to the trader's account on a monthly basis. Typically, forex dealers do not charge interest on trades opened and closed within a single session, but may charge rollover interest on positions held overnight.
If a trader's losses exceed the amount required in their margin account, they will be notified to deposit more money into the account to bring it up to a required maintenance balance. If they don't deposit money, the broker has the right to liquidate any securities or other assets held in their client's trading account to cover the losses. The broker can also raise future margin requirements in the trader's account. Traders should be aware that their losses can exceed the amount of funds they deposited. This is not just the full initial value of the trade but can include potential losses beyond that amount if their trading goes against them. In order to try to avoid extreme losses, traders will often use trading strategies that include stop losses and limit orders in their trade exit planning.
For the purposes of trading in financial markets, margin is a form of collateral against trades that are exposed to a risk of losses beyond a trader's available capital. When multiplied with leverage, margin can be an effective tool for traders to boost the amount of profits they can make with the capital they have on hand. Leveraged margin, however, can also multiply traders' liability for losses should their trades go against them, and it can cost traders' additional money in the form of interest charges.
Although use of highly leveraged margin may increase the potential for gains, traders should carefully consider the risks and costs of using it before entering their trades.
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Retrieved 04 Nov 2016 https://www.finra.org/investors/learn-to-invest/advanced-investing/understanding-margin-accounts
Retrieved 04 Nov 2016 https://www.aaii.com/journal/article/margin-accounts-a-double-edged-sword
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