Margin trading: understanding the risks and rewards of leverage.

Basically, margin trading refers to the capacity to take positions in excess of the total capital value that you would otherwise be able to given the size of your account.

In other words, it involves putting up only a fraction of the total cost of a trading position and essentially funding the deficit by borrowing money from the spread betting broker. The borrowed fund on the margin trading account attracts a financing cost—hence the charges that you might notice when you use rolling bets to take spread betting positions.

The issue of day trading on margin

As I have stated on several pages on this website, short term trading through financial spread betting or any other avenue for that matter is not a get-rich-quick scheme. Unfortunately, several years of a bull market led to numerous ‘free evening seminars’ and countless ‘UK’s leading stockmarket training’ courses being advertised in the media.

Most of these ‘seminars’ advocate day trading as a means of playing the market. Indeed, there are firms pushing products based on the idea of trading the markets from minute to minute and hourly basis, with punters trying to catch a few points here and there using extensive leverage. In my view, day trading on margin is the biggest trap that any novice trader can fall into.

Dangers of the abuse of leverage

Although the use of a margin account allows you to get more bang for your buck via the impact of leverage, it also exposes you to the possibility of losing more than you bargained for when things go against you.

Since trading in general, just as financial spread betting in particular, is a game of probabilities, you can bet that from time to time, things will go against you. It is at those times that the demerits of excessive use of margin trading come home to roost.

However, this is not just a mistake that small private spread betters make. Large hedge funds are often guilty of the same basic error of trading at a scale that is too large given the prevailing capital base. The likes of Long Term Capital Management which had a couple of Nobel Prize-winning economists on board; and Amaranth, a respected and supposedly diversified multi-strategy hedge fund, which lost 65% of its $9.2 billion assets in a little over a week were also guilty of flaunting this basic rule of margin trading and leverage use.