One of the biggest decisions you will need to make before you open your online trading account for trading stocks online, is whether to use a cash account or a margin account, and the one you choose will depend on several factors, not least your trading experience, your attitude to risk, and your stock trading strategy. Each will have an impact, and not least will be the view of your broker, who may decline to open a margin account for you, should you fail to fulfill the basic criteria. In the last few years, all the regulatory authorities around the world have been tightening up the rules in an attempt to protect the public from itself, as most are unaware of the risks involved in trading on margin. Indeed we have already seen this recently in the forex market, as the regulators threaten to impose restrictions on forex brokers with a maximum of 1:100 in a leveraged account. This is in stark contrast to the 1:400 currently being offered by several brokers at present.

The stock market is more tightly regulated, and the maximum margin currently available is 50%, which will only be offered to you, provided you meet the minimum criteria. By law your broker has to ask you to complete a signed questionnaire to provide a history of your trading experience, in order to qualify for a margin account. In addition, should you qualify for a margin account, once you start trading and are seen by your broker as a pattern day trader, then this may change the margin arrangements accordingly. So what is margin, why do we use it, and what are the benefits and risks?

Margin and leverage explained

In simple terms, trading on margin is using borrowed money to trade in the markets, and you borrow this money from your broker, who will of course charge you interest, as this is a loan. If we take a simple example, suppose we are buying 200 shares at £10 each, and have two separate accounts, one of which is a margin account at the maximum margin of 50%, and the other is a cash account. Assume the share price rises to £15 at which point we sell our shares, what has happened in each account, and why?

  • Cash account – we have made a £1000 gain on our shares. Against our original investment of £2000, this represents a return of 50% ( 1000/2000)
  • Margin account – we have also made a £1000 gain on our shares. On selling our shares we repay our broker the £1000 we borrowed to finance the trade, and take back our own £1000. In this case we have made a return of 100% ( 1000/1000)

This is a very simple example and ignores the costs of financing the trade, but the return is self evident. Using margin we have managed to double our return on our trading capital, simply by borrowing money from the online broker, and in effect doubled what is called our ‘buying power’. Now lets look at the second example where the news is not so good! In this case assume the share price falls to £5 rather than rising as expected.

  • Cash account – we have made a £1000 loss. Against our original investment this represents a loss of – 50% ( 1000/2000)
  • Margin account – we have also made a £1000 loss on our shares. On selling our shares we repay our broker the £1000 we borrowed to finance the trade, and are left with nothing. In this case we have made a loss of 100% ( 1000/1000) – all our trading capital is gone.

Such is the power of margin, that it leverages our profits and losses accordingly, which is why it is so risky, and should only be considered once you have some real trading experience, which is why the brokers will consider your online trading account application very carefully. Finally there are two types of margin that you will need to watch closely in your account, and these are the initial margin and the maintenance margin. The initial margin is the amount used on each trading position and required to open the position, whilst maintenance margin is additional margin required to cover the position as the share prices change second by second. This will vary all the time, and should it drop below the minimum level then you will receive a margin call from your broker – failure to provide additional funds to finance your shares will result in your broker closing your trades immediately.

So when considering an online account, give this apect of your account careful consideration, as it can have dramatic results, both good and bad! Finally, if you do open a margin account then do remember that you do not have to use the 50% maximum, you can use a much smaller percentage while you learn such as 5% or 1% on each trade, still offering you the power of leverage but at a much lower risk level.