Margin account and the risk of loss

Margin account: the basics

From a trading or investing perspective, a margin account is simply one that enables the use leverage or ‘borrowed money’ to enhance the returns on investments.

Consider two scenarios.

In scenario A, you have a trading account with a conventional stock broker. You place a trade for a 1000 shares in company X which is currently trading at £10 per share. The 1000 shares cost a total of £10,000 (excluding commission and stamp duty).

In scenario B, you use a margined account such as a spread betting account to execute the transaction. The 1000 shares are now simply represented by a £10 per point bet on a spread bet. For a margin requirement of 10%, the entire position would only cost you 10% of the total value. So, here, we estimate that your cost amounts to £1000.

A few weeks later, the share price has gained 5% so that company X now trades at £10.50 per share.

In scenario A, without the implact of leverage on your account, you have a trading profit of £500 (again excluding related transaction costs). This represents a gain of 5% on your invested capital.

—gain in the price of the underlying shares = 5%
—gain on your position = 0.05 x £10,000 = £500
—gain on your invested capital = £500 ÷ £10,000 = 5%

On the other hand,

In scenario B, using your levered account, you would have been able to use leverage to boost returns in the following way:

—gain in the price of the underlying shares = 5%
—gain on your position = £10 per point x 50 points = £500
—gain on your invested capital = £500 ÷ £1000 = 50%

In this simplified example, the availability of leverage on the account means that you would have turned a 5% gain on the underlying share price into a 50% gain on your account.

As the simplified example above demonstrates, the leverage results in a bigger net gain for you for any given gain in the underlying instrument. Of course, the reverse would be true in the even of losses. Where a trade goes sour, traders using leveraged accounts suffer much larger losses.

In summary, spread betting and cfds are margined products and as such, a spread betting or a cfd trading account would typically be a margin account. [I use ‘typically’ here because in the bid to attract more clients, some spread betting brokers are now planning to offer the benefits of financial spread betting without the risk associated with a margin account].

The amount of margin on offer varies across providers and across financial markets. For instance, direct access currency / forex trading margin accounts offer up to 400:1 leverage. This means that you have control over about 400 times the capital that you actually deposit into the account.

It becomes immediately obvious that you can see your profits grow very rapidly as each point move in your favour is multiplied by the margin factor. But do not get carried away. While a margin account has its merits, leverage is a two-edged sword!

Margin accounts and margin trading misunderstood

Someone once wrote to me telling me about how she felt that spread betting companies were ripping her off by asking for too much in margin deposit and thus tying up her limited capital that she could otherwise put to use in the market.

In my view, this sort of comment simply reflects the quite common misconception of margin trading and how margin requirements work.

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