Now you’ve seen how the power of leveraging works in our earlier section showing the difference between traditional investing and spread trading let’s explain exactly what margin trading is.
As we’ve said, in spread trading you never actually own a stock share or a commodity.
When you take £10,000 and buy a stock, like Jim in the example at the beginning of the book, you own that stock. You are now reliant on the Chairman, Directors and staff of that company to perform well. When they do; your £10,000 stock increases in value. However, when they don’t the share value diminishes and you are left with a share with less value than you paid for it.
A spread trade is very different from buying a share. You do not OWN the share, instead you are trading it based on a view that it will rise or fall in value.
With spread trading you’re only required to pay a fraction of the cost up‐front however you do need to have sufficient funds in your account to cover any potential losses. This is what we refer to as Margin Trading or Notional Trading Requirement (NTR).
Trading on margin is like trading with someone else’s money. If you make money on your trade, you get to keep the profits. But if the trade goes against you and you lose, you have to pay the company what you’ve lost them.
Most spread trading companies only require around 10% up front to place the trade. But you’re getting 100% of the trade: 100% of the profits, but also 100% of a loss.
Margin trading is also known as leveraged trading because you are leveraging the amount of money you are using to trade. Your £100 can get you a £1,000 trade.
Let’s say you want to buy £10 per point of M&S.
M&S is trading at 300.
£10 X 300 = £3000 (this would be the full cost of the trade)
10% of 3000 = £300 (this is the margin required to place the trade)
You’re maximizing just £300 into a £3000 trade!
Things You Need to Know Because of Margin Trading
You can lose a lot more money than you put up.
The ability to leverage your position opens up the possibility for greater trading profits. Of course, on the downside, being leveraged exposes you to losing more than your initial stake.
Take that example of buying £10 per point of M&S, when M&S is trading at 300. You only need £300 to make the trade. But what if M&S announces really bad earnings and its share price drops down to 200? You will have lost £10 X 100 points = £1000. You have to pay your trading company that £1000, even though you only paid £300 to make the trade.
Should this happen and there isn’t enough funds in your spread betting account to cover the loss (or potential losses on open trades) then your spread trading company will call you to ‘top up’ the account to the required level – this is what is known as a Margin Call. You are legally obliged to have enough funds in your account to cover any potential or actual losses. Each spread trading company has their own criteria and timescales for the customer to make the transfer of funds. You should make yourself aware of your company’s requirements.
Being on margin, you must be aware of this, because you must be prepared to pay that loss.
Because of the potential of losses while trading on margin, as if with someone else’s money, it’s important to place stop‐loss orders to protect yourself from losing too much. Many companies make it mandatory to use stop‐loss orders. But remember, you don’t want to put your stop‐loss too close to the price, because if it dips down just a little bit (and you think the price will go up in), all of a sudden it might shoot up in price, and you would have lost out on that profit just because of that little dip.