More and more investors are finding strategies to prosper in the financial markets without maintaining huge capital reserves. Margin trading implies taking up a larger stake in the market by borrowing money from one’s broker.
However, some describe this approach as highly risky because it may lead to becoming indebted to the broker and even liquidating one’s account if not managed properly.
Unlike trading with cash, margin accounts involve some calculations and proper planning to secure the maintenance margin. Let’s discuss how you can trade with margin.
Understanding Margin Accounts
Margin trading entails utilising the broker’s services and borrowing money to explore market positions with high return potentials. Traders use this approach when they do not have sufficient equity in their account and want to capitalise on unmissable market opportunities.
For example, a trader may predict that Apple’s stock price will increase upon a new product launch and want to purchase 100 shares, each at $200. However, the trader only has $1,000 in their account, so this market order will cost at least $20,000.
Using the margin account, the trader can provide 1:20 leverage, multiplying your 1,000 balance by 20 and enabling you to execute a market order at $20,000.
What Is Maintenance Margin?
Opening a margin trading account requires a maintenance margin. It is the amount of equity a trader must maintain as collateral for their broker in order to maintain an open position.
Each market order has a unique maintenance margin that is determined by the broker’s structure and rules. As a proportion of the total margin traded in the market order, the trader’s collateral serves as an indication of how much money is remaining in the account before the broker issues a margin call.
How is Maintenance Margin Calculated?
The investor must keep the amount of the maintenance margin, and if the market goes sideways and the open position loses its value, once the balance drops to the margin level, the broker will produce a margin call.
The margin call is a request to add more funds to your margin account to keep the leveraged trading position and avoid getting a negative balance. The broker may close the account or liquidate assets in your account to avoid excessive losses.
Leverage, traded volume, initial margin, and broker guidelines all play a role in determining the minimum required maintenance margin.
Margin trading carries the risk of the investor owing money to the broker in the event of a losing market position. Therefore, only traders who are willing to take on significant risks and who have access to substantial cash should use this strategy.
The maintenance margin (variation margin) requirement can be used as a risk assessment tool that indicates how risky is the trade proposal and what you can expect if the market moves in an unfavourable direction. Therefore, careful calculation and analysis must be conducted beforehand.
Maintenance Formulas
One straightforward approach to calculating the exact amount needed for the variation margin is measured using the following formula.
Variation Margin Level = (PA * AEP * VMR) + AACP
Whereas:
PA – position amount.
AEP – average entry price.
VMR – variation margin rate.
ACCP – assumed commission for closing the position.
However, a trader may calculate the average position price using the following formula.
Average Position Price = TCV / TTA
Whereas:
TCV – Total contract value.
TTA – Total transaction amount.
A margin call happens when the leverage trade drops in value and reaches the maintenance margin amount, ordering the investor to add funds to support the trade before the position is liquidated. The margin call price can be calculated as the following.
Margin Call Price = P0 (1 – initial margin / 1 – maintenance margin)
Whereas:
P0 – initial purchase price.
Margin trading with leverage has distinct considerations, and each broker may have different requirements despite the aforementioned standard formulas.
Therefore, it is recommended that you check with the broker about the margin elements, calculations, amounts and collateral before indulging in leverage trading.
Final Takeaway
Trading on margin means borrowing money from a broker in order to make larger market orders with the expectation of better profits. However, the trader runs the danger of being in deep debt to the broker if the market turns against them and their position loses value.
To keep a leverage trading position open, the trader must retain a sum equal to the variation margin in their trading account at all times. In order to capitalise on once-in-a-lifetime trading chances, risk-takers often use this method.