In simple terms trading on margin (whether in a spread betting account or any other), is trading using borrowed money, nothing more, nothing less. Let me give a simple example (I like simplicity!). Suppose you are playing poker and have what you think is a good hand. You have already put £100 on the table, but you have no more funds available. The first option is to fold and walk away from the table having lost £100, in other words 100% of your money. Option two is to borrow some money from a friend and carry on with the hand. Let’s assume this happens and you borrow an additional £100 but still lose the hand – in this case you have lost your own £100, the borrowed £100, but you now owe your friend a further £100 ! Let’s look at the maths of this simple example as follows:
Option One – In this case you have only lost your own £100 and owe nothing, so your total loss in percentage terms against your starting capital is £100/£100 i.e. 100%
Option Two – In this case you have lost your own £100, a borrowed £100, and you owe a further £100. Your total loss is £300 and in percentage terms against your starting capital is £200/£100 i.e. 200% ( double!)
This is the danger of trading on margin – you can lose substantially more than your starting capital. Many novice traders enter financial spread betting from a stock or share trading background, where trading accounts are generally cash only, although margin accounts are available for more experienced traders. So in a simple share trading account, when you buy 200 shares in HSBC at £4.50 per share, your account will be debited with £900, the cash equivalent. If the shares fell to zero, your maximum loss would be £900 ( £900/£900 *100%) or 100%, no more no less. Had you been trading using a margin account where your broker had lent you the other 50% ( as in the card game example above) of capital for the trade, then in this case you would have lost (£450 + £450)/£450 *100% = 200%. The problem with margin, and the reason it is so attractive to many novice traders is that ofcourse it works the other way round. Whilst losses are magnified, so are profits, so with a small amount of trading capital you can make large profits. If we take the above example again with the HSBC shares, suppose now the share price doubles to £9 per share. How does the maths work now :
Our shares are now worth 200 x £9 = £1800
We sell them and pay back our broker the margin amount borrowed of £450
We are left with a balance of £1800 – £450 = £1350
Our profit after deducting our original stake is £1350 – £450 = £900
Our % return is therefore : profit ( £900) / original stake (£450) = 200%
That’s the danger of trading on margin – the returns can be substantial, but so can the losses. In addition, a margin account gives you the opportunity to spread bet large positions with a small amount of trading capital which again can be fatal for novice investors in the financial spread betting market. Now another term you will hear is leverage so let me explain that one so you have a complete picture.
In financial spread betting, you will come across both the terms margin, and leverage, which in essence are the same thing, but expressed differently! Again in simple terms margin is generally expressed as a percentage ( as in the above examples), whereas leverage is generally expressed as a ratio. You will often see a spread betting company offering an account with “leverage” of 1:50 so what does this mean? All this means is that this is the same as saying a margin requirement of 2% or 1/50 * 100 = 2%. So whether a broker offers an account with leverage of 1:50, or they require a margin of 2%, then these are one and the same thing. In both cases you will need to have a minimum of 2% of a particular trade size in your account, before you can open the trade. I hope that clears that one up.
Whenever you borrow money from anyone, you pay interest! This often comes as a surprise to new traders, who seem to think that the spread betting companies provide you with money because they are kind and generous souls, with a desire to spread some good in the world. Get real – you will be charged interest on the margin and you should check this with the company before opening an account, (it is very profitable part of the business, for them!). This is one of the reasons most spread betting is done on a short term basis, as the interest charges will cripple your profits if you are holding large positions over long timescales.
