Present opportunities of margin trading.

Appearance of margin trading greatly changed the idea about participants of international financial markets. It is well-known that operations of purchasing of securities or currency are worthwhile only with large sums of money, for example, at the inter-bank market the minimum transaction is carried out with $1,000,000. For their clients banks (brokerage houses, dealing centers) can carry out operations with smaller sums - from $100,000, i.e. conclude transactions with a part of the principal sum.

  • The minimum possible sum, with which a transaction can be concluded, is called a lot.

In the above example, 1 lot is $100,000. At the stock exchange a lot is measured in quantity of securities; for example, 1 lot may be equal to 1000 shares. With average price of a share $50, 1 lot is quite a sum, which automatically closes access to financial markets for investors with small resources.

Due to increased public interest in speculative operations with securities, banks developed an interesting mechanism for attraction of economically minded, but not rich people to this profitable business. Instead of $100,000 it is enough to have, for example, $1,000, serving as a pledge and allowing the investor to carry out operations on the bank's behalf with a sum 100 times higher. This pledge is called Margin. It gave the name to the most popular principle of trading at financial markets - Margin Trading.

  • Margin Trading consists in purchase with consequent obligatory resale of currency or securities with funds, borrowed from the bank exclusively for this operation.
  • Ratio between the pledge and the sum of credit is called Leverage.

In our case Leverage is 1:100. In other words, own capital of the investor is only 1% of the transaction size and serves as a guarantee from possible losses.

Пример.

  • Deposit 5000$;
  • Leverage 1:100;

Under such conditions, the investor can open a position not exceeding $500,000 (= $5,000 * 100) or equivalent in other currencies. If the investor opens the position not for $500,000, but for $100,000, it means that he has not used his entire deposit ($1,000=$100,000/100) and free margin ($4,000) can be used for opening of other positions.

The bank's "generosity" to the investor is explained easily: the investor does not receive any cash, and that is why he cannot spend it. The investor just has the right to operate the credit sum on behalf of the bank, carrying out speculative operations, i.e. buying some assets and selling it at higher price.

  • The main task of a speculator is to buy an asset cheaper and sell it later. This difference in price is the investor's profit.

If operations are successful, all income is deposited to his account; if not, the bank compensates losses with the investor's deposit. Correspondingly, all profits and losses from trading operations belong to the investor. Thus, during margin trading, conclusion of a transaction is subject to obligatory closing of the position by a reverse transaction. When the position is closed, derived profit is deposited to the investor's account, or losses are deducted from the account.

The bank constantly tracks the status of the client's account. It is done in order not to lose more money, than deposited on the investor's account. Otherwise, the bank will have to bear a part of losses. Losses may not exceed the minimum level of the deposit (usually expressed in percentage), since the bank forcibly closes the client's position at the current rate. That is why the investor will not become a bankrupt, and the bank will always save his credit.

  • The minimum margin level, when the broker forcibly closes the client's transaction, is called stop out.

Now stop out is usually 20-30% of the margin. Moreover, for the last 10 years, liquidity of markets has considerably increased, which allowed many big market operators to offer their clients an opportunity to carry out transaction with 1/10 lot (about 10,000 USD for currency markets and 100 stocks for stock markets). Thus, current requirements to the margin reduced to 100 USD, and stop out is 200-300 USD for a standard lot and $20-30 - for 1/10 lot.

If interest of investors toward margin trading is obvious, why does the bank need this procedure, if it does not participate in profits?

The bank is interested in this business, first of all, because it always makes profit on difference between buying and selling prices. Banks offer prices on each instrument traded by them as Bid and Ask prices, at which they are read to conclude transaction. An example is a regular exchange office, where currency rates are always indicated as two prices - at Ask price the client can buy foreign currency (the bank sells it to him), and at Bid price - to sell it (the bank buys from him).

  • Spread is the difference between Ask (buying price) and Bid (selling price).


Example.


At an exchange office, the bank offers two prices, for example: the bank buys dollars (USD) at 1.2100 Swiss franc (CHF) per dollar, and sells at 1.2200 CHF. Hence, Spread is 1.2200 - 1.2100 = 0.01 CHF. If the client wants to sell $100 to the bank and then immediately buy them, the operation will look as follows:

  • The bank buys $100 from the client at Bid price - 1.2100 CHF * 100 = 121 CHF;
  • The bank sells $100 to the client at Ask price - 100 * 1,2200 CHF  = 122 CHF;

In the result, the bank earns 1 CHF or (1/1.2200) = $0.82 at the current rate and the client will lose it.

Let us review another situation.

EUR/USD

At an exchange office, the bank offers two prices, for example: the buy euro (EUR) at 1.2300 USD per EUR and sells at 1.2400 USD. Hence, Spread is 1.2400-1.2300=$0.01 (one cent). Say, the client buys 1,000 EUR from the bank and some time later he sees, that EUR has grown and the bank offers the following prices:

  • Bid 1,2650
  • Ask 1,2750

Then the client understands that he can make profit and sells the same 1,000 EUR he bought to the same bank. His operations will look as follows:

  • The client bought (bank sold to the client) 1,000 EUR at Ask price =1.2400;

          1,2400 $ * 1000 = 1240 $;

  • The client sold (bank bought from the client) 1,000 EUR at Bid price = 1.2650'

          1000 * 1,2650 $  = 1265 $;

In the result, the client earned 25 USD. The bank also earned its Spread = $0.01*1000=$10;

Thus, the client makes profit, if he correctly selects the direction of price movement, and the bank makes profit in any case. This is what makes this business so attractive to financial institutions.

An additional income item for the bank may be a credit usage charge. The bank loans some money to the client and wants to receive interest for this. The particularity of this is that the loan fee is charged for a certain period, for which the sum is required. The minimum period is one day; so, if the client opens a transaction and then closes it within one day, the credit is provided to him for free, and if the client leaves the position open and moves it to the next day, then interest is charged. During transactions at a currency market (FOREX), cost of credit depends on the difference of interest rates in currency pairs (LIBOR) or is just established by the bank. Usually this is a very small sum - small in comparison with profitability from credit usage. It is approximately 0.01% (about $10 per day for operations with a standard lot and $1 for operations with 1/10 lot, for usage of $100,000 and $10,000 respectively) and is called SWAP (Storage) or overnight.

  • SWAP is the cost of a credit for leverage usage, is the transaction is shifted to the next day.


First making its appearing at the stock exchange about 100 years ago and becoming accessible only in the 1980's, margin trading became so popular, that it allows millions of people now to trade at financial market every day, using as an insurance deposit just a small part of necessary funds.

These are the basic particularities of modern margin trading:

  1. Small initial capital allows carrying out of transaction for sums, exceeding it by many (tens and hundreds) times.
  2. The credited sum may be issued in any currency, even different from the currency of deposit.
  3. Profits and losses are calculated from the credited sum and may be very considerable in relation to the insurance deposit.
  4. Trading is carried out without actual money delivery, which reduces overhead costs and allows opening of positions by buying or selling assets without any special formalization.
  5. If trading is carried out only during one day, when an open position is not moved to the next day, the credit is provided for free.
  6. Like with traditional investments, the bank or the broker can charge interest rate on free margin of the client. Due to active funds usage, interest rate may be a little higher than average.
  7. Trading can be carried out remotely, via the Internet.


As far as the capital grows, the participant of margin trading has more opportunities, and, depending on funds available, the investor can set and solve different tasks.

  • Managing a deposit over $2,500, it is possible to study financial markets, to keep up on international events, to test different approaches to trading without much risk to lose modest savings. At the same time, it is impossible to count on big profits;
  • Deposit over $5,000 allows carrying out of professional trading with a considerable addition to the basic income source. Strategy of capital management gets stronger and intellectual exercises are combined with financial benefits;
  • Deposit over $10,000 gives an opportunity to realize complicated trading strategies, and in case of successful trading, profits can be considerable. Such deposit allows using various instruments of international financial markets in trading and opening of transactions with several lots;
  • Deposit of $25,000 allows the investor to earn not only on change of cost of financial instruments, but also to received considerable dividends on investments (Intereset Rate), if it is not provided in the brokerage company.
  • Trading with 1/10 lot is also possible, since it requires very small deposits (a few hundred dollars). Such deposits are mainly used for training purposes or to test trading strategies.

Margin trading is a rare example, when a 'bright head' with a small initial capital is able to turn poignancy into wealth and an initiative into success.

*  This article has been prepared and written by the specialists of analytics department of the Company Larson & Holz IT Ltd. in 2004.
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