The Pros and Cons of Margin Trading

How much leverage do you think you can handle?

When you first start trading or investing, this is a theoretical question that fascinates the imagination. Leverage fuels some incredible money-making opportunities. But it can also be the most disastrous thing that could ever happen to a trader.

Let’s explore how margin trading is defined in different sectors of the trading industry along with the risks, rewards, and reality.

What is margin trading?

Margin means different things in different marketplaces. Margin is the leverage that a brokerage firm allows you to have when you trade.

In the forex and the commodity futures arena all assets trade on relatively small margins and all that is required to create a position is a good faith deposit, dictated and regulated by the exchanges. This is also known as the initial margin requirement. For example, in forex it is not uncommon that you can control $100,000 worth of a currency with a small deposit of $3,000.  This is considered highly leveraged trading. When you divide the value of the asset by the value of the initial margin requirement it will give you the exact amount of leverage.

In this case it is 33.33 to 1.

A forex broker is not loaning you the additional amount to create the position. They are simply requiring that your account maintain a certain balance to remain in good standing and keep the entire position open.

In this example, a forex broker will often say that your account will need to maintain a $2,000 balance to be able to keep the entire position open.

Should your balance ever fall below $2,000 you will receive what is known as a margin call which is a request by the broker to deposit enough funds in the account to bring the balance back to the initial margin requirement of $3,000. Usually, these funds need to be deposited with the broker within 24 hours or the brokerage reserves the right to liquidate your position.

At its very core what you need to understand is if you control 100% of an asset with a 3% deposit, in essence this type of leverage implies that a 3% move in the underlying asset will create a 100% profit or loss for the trader.

The reason that most traders lose money in trading is because they are Undercapitalized and Overleveraged.

Brokerage houses in the forex trading arena will give you as much as 500 to 1 leverage. They almost beg you to be undercapitalized and overleveraged. Having 500 to 1 leverage is comparable to trying to drive a NASA rocket ship to your grocery store. I can almost guarantee an accident is going to occur.

Truth be told in forex trading, you as the trader create the amount of leverage that you want.  To most traders this is like a narcotic. They want as much leverage as possible.

Regardless how good of a trader you think you are, your arch enemy is being overleveraged and undercapitalized. The fastest way to lose money is to be undercapitalized and overleveraged.

You’ve probably heard people say that trading forex or commodities is risky. The industry statistics promote that roughly 90% of forex and futures traders lose money.

Those markets are not any more volatile than stocks, but they are significantly more leveraged and that is what creates the risk and the reward opportunities for traders. Whenever you have 500 to 1 leverage it means that a .2% move in the underlying asset will create a 100% profit or loss for the trader.

Here is how this works in the commodity futures markets.

Let’s say Corn is currently trading at $5.25. Its contract size is 5,000 bushels. Thus, the total value of the contract is $26.520. A trader can create a position, either, long or short, in Corn for the initial margin requirement of $2025. The maintenance margin requirement is $1300.

The margin requirements are dictated by the exchanges where the underlying asset trades.  Sometimes the broker will add a % to the margin requirements to force their customers to be better capitalized.

What this means is that with roughly a 5% deposit, a trader can control $26,000 worth of corn.  If corn moves 5% higher the trader makes 100% profit. If corn moves 5% lower the trader wipes out his account entirely.

Over the past year, Corn has traded as high as $5.41 and as low as $3.32.

Annual Price Range of Corn 5,000 bushel contract

Next time you look at a corn chart, look at it through the eyes of a corn trader who is looking for a 5% move one direction or another, to try and make 100% on margin. You will now understand how a market that has a $2.09 annual trading range can create or lose massive fortunes for traders. That $2.09 annual range is the equivalent of $10,450 potential gain or loss for traders who only have to put up a $2,025 initial deposit to be able to trade the asset.

As long as the traders maintain a balance in their account is $1300 or larger (the maintenance margin requirement), they will not receive a margin call. However, if their balance falls below $1300 they will be required to wire more funds into the broker to bring their balance up to the $2025 initial margin requirement.

Worth remembering in forex and futures:

Margin is the deposit needed to place a trade and keep a position open. Leverage, describes the capital outlay required to control the entire underlying asset.  In these arenas you are not borrowing money to trade the underlying asset.

Margin In the Stock Market

Consider the following scenario: you’re sitting at a blackjack table and the dealer deals you an ace. You know that you are in the power position now. You’d like to increase your bet, but you are a little short on cash. Your friend agrees to loan you $100 and you can pay him back later.  Now you have a very challenging decision to make. The odds are in your favor but, in reality, you can still lose. If the cards are dealt correctly you can win big on this hand and pay back your friend with the loaned money.  But what happens if you lose?  I urge you that you discover your leverage threshold by opening a demo and practice keeping your positions small so that you can keep your objectivity and trading to be as stress free as possible.

Most high leveraged traders usually blow themselves up long before they hit their 100^th trade. Learn from their tragic experience and make sure you don’t repeat their results.

Great traders look for consistency in their trading results.

I track all of my trades and every hundred trades I develop my metrics.

What was my average winning trade?

What was my average losing trade?

What was my biggest win?

What was my biggest loss?

This discipline has been necessary for me to develop an understanding of what it takes to be successful in trading.  By doing this I have developed huge confidence in my abilities. This confidence has been a result of tens of thousands of trades and learning from my mistakes.

I’ve learned instead that trading is largely defensive. If I take care of my losers as a top priority the winners will take care of the rest.

In trading you have to become expert at taking losses, and not looking back.  This is much easier said than done.  But if you recognize that your ego is the enemy, taking losses becomes an essential part of the activity.

Risk is by definition the threat of loss due to uncertainty. 

A great trader does not have to have all the facts to be able to act upon a solid trend that is in motion. Trading at its essence is finding a strong trend and deciding where you get in and where you get out. Ideally what a trader wants to know is where do the strongest trends exist.

This is why artificial intelligence is an absolute necessity for traders today. Look at the following chart of the S&P 500 Index with the LucyAI A.I. Forecast.

S&P 500 Index (10/20 thru 1/2021)

This forecast has proven to be up to 87.4% accurate in predicting the future trend of the stock market.  I think you’d agree that is far more impressive than any of the narratives you just read about.

Our forecasts are created by looking at the top 32 drivers of an asset’s price. We do this from the foundational perspective that we live in a global marketplace. What happens in one part of the world has global implications and your charts and analysis need to communicate this information to you before you ever think of putting on that next trade.

Moving forward I want you to think long and hard about HOW you are going to trade the markets if you do not have an edge. As the volatility of the past few months becomes commonplace are you prepared?

S&P 500 intermarket

Think about those losing trades and ask yourself what did you learn from that experience? What is your method for analyzing risk?

Are you capable of finding those markets with the best risk/reward ratios out of the thousands of trading opportunities that exist?

Knowledge.  Useful knowledge.  And its application is what ai delivers.

Artificial intelligence is not “a would be nice to have” tool.

It is an “absolutely must have” tool to flourish in today’s global markets.

Make it count.

IMPORTANT NOTICE!

THERE IS SUBSTANTIAL RISK OF LOSS ASSOCIATED WITH TRADING. ONLY RISK CAPITAL SHOULD BE USED TO TRADE. TRADING STOCKS, FUTURES, OPTIONS, FOREX, AND ETFs IS NOT SUITABLE FOR EVERYONE.

DISCLAIMER: STOCKS, FUTURES, OPTIONS, ETFs AND CURRENCY TRADING ALL HAVE LARGE POTENTIAL REWARDS, BUT THEY ALSO HAVE LARGE POTENTIAL RISK. YOU MUST BE AWARE OF THE RISKS AND BE WILLING TO ACCEPT THEM IN ORDER TO INVEST IN THESE MARKETS. DON’T TRADE WITH MONEY YOU CAN’T AFFORD TO LOSE. THIS ARTICLE AND WEBSITE IS NEITHER A SOLICITATION NOR AN OFFER TO BUY/SELL FUTURES, OPTIONS, STOCKS, OR CURRENCIES. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE DISCUSSED ON THIS ARTICLE OR WEBSITE. THE PAST PERFORMANCE OF ANY TRADING SYSTEM OR METHODOLOGY IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. CFTC RULE 4.41 – HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY.