The COVID pandemic brought a massive influx of new day traders into the market. Many of these new day traders are operating via margin trading. Here we examine what margin trading is, the best trading platforms for margin trading and how margin trading can be used responsibly by the day trader with a small account.
What is Margin Trading?
An account that allows margin trading is basically one in which a trader or investor is allowed to use the current cash or equity in their account as collateral for a loan. This extra money or leverage can then be used to trade a financial asset.
Best Trading Platforms for Margin Trading
TradeZero is a trading platform that offers an excellent offering for margin trading. Once approved for margin trading with TradeZero, a trader can access leverage on the money in their account based on their country of residence.
The Risks of Margin Trading
The leverage offered by margin trading tends to amplify both losses and gains while trading.
Amplifying gains is the beauty of margin trading and we will examine this in detail. Firstly though, let us look at the other side of the coin and examine the risks of margin trading and how it can amplify losses.
How Not to Use Margin Trading
Trading is hard and before learning how to win at this game, we must first learn how to manage risk.
Once we learn this we must then remember it forever or risk blowing up our account.
Not having a proper risk management strategy or edge while using margin trading is basically a shortcut to blowing up.
Here I will outline an example of poor use of margin trading.
For ease of calculation I will use round numbers:
Let’s say you have deposited $2,000 in your trading account and have been approved for margin trading. Your strategy pinpoints what you consider to be a very good trading opportunity on a stock called $MOON. This set-up is A+ and you decide you want to use your 4:1 leverage to take bigger size than the $2,000 in your account.
$MOON is currently trading at $5 and you believe it can go to previous resistance in the $6.60’s.
You use the $2000 of your own equity to buy 400 shares.
You have identified a risk area based off of a previous key level of $4.50. You are therefore risking 10% of your equity as below $4.50 you will exit the trade as your thesis is no longer valid. The amount in $ you are risking is therefore $200.
Because this is such a good opportunity you want to use all of your leverage. The price is fluctuating around $5 as you add to your position until all of the $8,000 that your margin trading account offers has been invested in $MOON.
Your average price is $5.
The price suddenly dips to $4.75 which has you 5% in the red. This is not a problem as $4.75 is still 5% above your designated risk area of $4.50. However, because you are now margin trading at 4:1, the 5% red is actually 20% of your equity and you are down $400, which is double your intended max loss despite still being 5% above your risk area.
The chart is still intact and your thesis is still valid. It’s a great opportunity so you decide to hold for the $4.50 risk area.
You see where this is going, right?
By the time $MOON hits your $4.50 risk area you are now down $800 which is 40% of your whole account and four times more than you intended to lose. If you decide to get stubborn and not take the loss, $MOON only has to hit $3.75 before you will be in the red by the full $2,000 that is in your account. At this point you may be margin called by your trading broker, which basically means your position will be liquidated and you are automatically exited.
And your account is empty.
Responsible use of Margin Trading
Responsible use of margin trading involves sizing gradually into a winning position and moving up your risk so as to avoid blowing up.
Again using the example above with $MOON
You decide to add in 5 lots of $1.6k to utilize the 4:1 leverage that your margin trading account offers.
You buy 320 shares at $5.
You don’t buy anymore shares until $5.30, when you buy 2 more lots of 320 each.
You add the remaining 2 lots of 320 shares between $5.30 and $5.50.
Your average is $5.25.
The point at which you will be down the designated max loss of $200 is now $5.12.
The stock is currently at $5.50 so you have some room to play with as you are currently 7% above $5.12. The play is working for you and you have some cushion.
You are now in control of the trade and your risk is under control because you used margin trading responsibly by adding to a winner, not a loser.
If $MOON goes on to hit your target area of $6.60’s you will come out with a 25% winner, but because you used margin you will actually double your account from $2,000 to $4,000 as 25% of the $8,000 you used via margin trading is equal to $2,000.
Yet you were only ever risking a max loss of $200.
In effect, because you used margin trading responsibly, you were able to have 10:1 risk reward and double the size of your small account in 1 trade. Without margin trading, your 25% gain would only have given a $500 profit while risking the same $200.
Margin trading allows a trader to use the cash in their account as collateral to borrow money from their trading broker to trade with. Different trading brokers offer varying leverage packages for margin trading on their trading platforms. It is important to find the best trading brokers to suit your needs and account size. Margin trading is inherently risky when not done correctly, but it can be the best way to grow a small account if done with a proper strategy. It is therefore very important while using margin trading to trade responsibly, for example, by adding correctly to a winner rather than adding to a loser as this can blow up your account prematurely.
This content (“Content”) is produced by John Maher. The Content represents only the views and opinions of Mr. Maher. Mr. Maher’s trading experiences and accomplishments are unique, and your trading results may vary substantially. TradeZero does not endorse the Content and makes no representations or warranties with respect to the accuracy of the Content or information available through any linked third party sites. The Content has been made available for informational and educational purposes only and should not be considered trading or investment advice or a recommendation as to any security. Trading securities can involve high risk and potential loss of funds. Mr. Maher’s is compensated by TradeZero for producing the Content and may also receive compensation for customers he introduces to TradeZero.
TradeZero provides self-directed brokerage accounts to customers through its operating affiliates: TradeZero America, Inc., a registered broker-dealer and a member of FINRA and SIPC; TradeZero Inc., a dealer registered with the Securities Commission of the Bahamas; and TradeZero Canada Securities ULC, an IIROC member firm and member of CIPF.