A Beginner’s Guide to Margin Trading Vs Stocks Trading

Over the last few years you have doubtless noticed the value of your pension pot going down (quite dramatically at times) and you may have also noticed a number of the larger banks trying desperately to “divest” their portfolio away from equities and into anything else – although if you look at some of the choices that they have made you may wonder if they were trying to go from bad to worse deliberately.

So, I started with the pretty bold statement that you should consider trading forex instead of/as well as equities – what’s that all about?

Let’s start with a couple of definitions just so that we are all on the same page.

When I use the word “Equities” I am referring to shares of a specific company, so IBM or Yahoo shares for example. When I talk about “Forex” I could be talking about one of two things – “Spot” or “Margin” trading.

For those who are new to trading “Spot” trading could be best described as physically performing a trade to purchase a currency against a currency that you already hold. A good example of this would be if you live in the Europe and you’re going on holiday to the USA – you need to buy USD and to do this you’re going to sell EUR. So – Spot = physical conversion of currency.

So what’s margin trading?

When we trade on a margin account we are able to perform trades with a value which are considerably higher than the amount that we have deposited – this is because of something called leverage. Leverage is typically expressed as a ratio so if you have leverage of 100 then you have effectively got 100:1 purchasing ability (you can buy 100 USD when you only have the funds for 1 USD). Leverage allows you to purchase a lot more of a currency then you would ordinarily be able to afford – but then this is where the word “Margin” comes back into focus.

Let’s take the example of you purchasing 100 USD as an illustration and let’s further imagine that our account has 5 USD in it. We’ve purchased 100 USD and so 1 USD of our money is accounted for – this leaves us with a balance of 4 USD. If the market moves in our favour then we’re making 100 times more money than we would normally be able to make BUT the opposite is also true. So if we take an outrageous example of the market moving against you by 400 USD then we would have no money left (our position would be worth 500 USD and our own exposure would be 5 USD) – and if we assume that the market moves against us by 1 Cent more then we would not have enough money to cover our position and so something called a margin call would happen (the brokerage will close the position or ask you to deposit additional funds – although they would have done this when we got down to .1 USD own money left). So that’s a brief description of margin trading – why did I mention it?

Typically when we as a retail client (or non-institutional client) purchase equities we buy what we can pay for – not 100 times what we can pay for. So with Forex (margin) trading we can leverage our investments and potentially make much more than would otherwise be possible.

What about trading strategies?

When we trade forex we can go long or short (buy or sell) – that’s right, we can sell something that we don’t actually have, with equities it’s not possible to go short that is to say if you want to sell something you need to own it first. With equities there are two types of short selling – Naked and covered. Naked short selling refers to the practice of selling something that you do not own and potentially do not have access to, covered short selling involves technically borrowing the equity that you wish to sell from someone else (and you pay a premium for this service). At the time of writing naked short selling is not allowed.

One interesting point to note about short selling is that the investor is trying to benefit from the negative movements in either the market or a specific stock/currency. The process was banned after the 2008 market crash although it had already been in question since shortly after 911.

This has an effect on trading strategies for asset managers, it effectively means they are tied to long only strategies unless their strategies are robust enough to cover borrowing equities from elsewhere (the premium required varies by institution but can be costly) – Forex strategies in comparison can include long and short selling with no penalty for short selling. Long only strategies entail the asset manager buying equities and then holding them until they make a profit or decide to take the loss – so they don’t benefit from market volatility in the same way that Forex traders can.

What about exiting a trade?

We’ve talked about entering trades, long and short, but what about when we want to close a position and take our gain (or accept our loss)?

The Forex market is worth over 5 trillion USD a day (yes, per day) this has the effect of ensuring that there is liquidity for any currency pair that you can trade 24 hours a day and given that forex trading is classed as OTC (over the counter) it’s not linked to a specific exchange (such as the NYSE or LSE for example). So what about equities?

An equity is typically linked to a single exchange that is to say that one symbol will be listed on a single exchange (although it is possible to have something called fungible assets which we’re not going to go into right now). This link to a single exchange ensures that the exchange has to be ‘open’ in order for the trade to be processed (closed) and given the limited liquidity of individual equities you obtain the price that someone is prepared to pay when you close your position – with the Forex market being as large as it is the price you achieve is typically almost exactly the price you see on the platform.

So in summary, Liquidity, short selling and leverage – three good reasons why you should consider GSBM trading Forex instead of equities – there are many other reasons including ease of access, availability of trading strategies, extensibility of the trading technologies and capturing market volatility but these three are a good starting point.

 

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