How does margin affect trading risk?

How does margin affect trading risk?

Reading time: 9 minutes

Traders and investors often confuse what margin is and how it works. This concept – and its relationship with leverage – matters a great deal.

It becomes even more confusing when people say you need to control leverage. However, risk per trade drives position size, and position size drives margin and leverage, not the other way around.

So, rather than just focussing on margin, it is important to look at the entire picture.

Risk tolerance: Risk per trade

I will start with the most basic, albeit incredibly important concept: risk per trade. To be clear, though, I am explaining this for beginner-level understanding.

Trade risk is essentially what you are ‘comfortable’ risking per trade. Most traders risk between 1% and 2% per trade. So, if you trade a US$10,000 account and risk 2%, your trade risk is US$200. However, some scale risk based on the quality of the setup. For example, in an A+ setup where all the entry criteria align, some traders might increase risk to 3%, while a C+ setup, with a lower win rate, may warrant only 1% risk allocated to the position.

As you can see, percentage risk can depend on the setup, but for most traders, percentage at risk stays the same; importantly, the dollar amount at risk changes in lockstep with your account equity. Say you start with a US$10,000 account and risk 2% per trade (US$200); after two winning trades, your account is US$10,500, and your dollar amount at risk is now US$210. If those two trades had instead been losses and your account fell to around US$9,600, your 2% risk would drop to US$192.

Sizing your position

Position sizing deserves an article (or three) to itself. It is certainly beyond the scope of this segment to explain the inner workings of position sizing. However, the following will help to get you started.

The basic formula:

Once you have position size, you can check how much margin the position requires and confirm it leaves a comfortable buffer in your account.

Define margin & leverage in simple terms

Margin trading is standard in foreign exchange (Forex), futures, contracts for difference (CFDs), and leveraged share dealing, and many promote it as a way to make capital work harder. In this article, I will focus on CFDs and, primarily, how margin affects trading risk. In my view, traders are risk managers first and foremost; therefore, this is essential learning for all traders.

I want to start by saying that a leveraged position in the CFD market is not a loan in the traditional sense. It makes no sense to think that a broker loans you US$100,000 for a US$1,000 deposit. Why would a broker (or any institution, for that matter) lend you 100 times your deposit with no security?

When trading CFDs, you trade derivative contracts that are always cash-settled. This means there is never physical delivery; for example, if you trade oil, you will never receive barrels of oil because you are simply entering into a contract, and profit and loss is calculated from the position's opening and closing prices. Margin is the ‘collateral deposit’ that covers both you and the counterparty in the event of a large adverse event. What I mean is that if account losses become extreme, margin can help you avoid going negative.

Margin and leverage are two sides of the same coin. Margin is the ‘collateral you put up’; leverage is how many times larger your position is than that deposit. Margin does not alter the probability that a trade will be right or wrong.

Regulators, the instrument, and the account type usually set your leverage. Let’s assume it is fixed at 100:1. To calculate margin, you simply divide 1 by 100 to get 0.01, or 1%. This 1% is your margin percentage, meaning that for every trade you take, 1% of the notional position size will be your margin deposit. If you are trading a US$100,000 position, the margin will be US$1,000. If your position size is US$500,000, the margin will be US$5,000. As you can see, the bigger your position size, the more margin is needed.

Also, note that the higher (lower) the leverage ratio, the lower (higher) the margin requirement. For instance, if you trade with a leverage ratio of 30:1, your margin percentage would be about 3.3%. However, with a leverage ratio of 500:1, your margin percentage would be about 0.2%.

What is a margin call?

To understand the mechanics behind a margin call, you need three figures:

• Used margin: the deposit currently tied up in your open positions.
• Equity: your account balance plus or minus the floating profit or loss on open trades.
• Margin level: equity divided by used margin, expressed as a percentage.

A margin call from your broker is something you want to avoid. It warns that your trading account equity has fallen to equal the margin (so the margin level percentage will be 100%). This means that your ‘free margin’ is effectively zero and that no additional positions can be opened. At this point, you would need to add funds or reduce exposure in open positions. You will not receive a margin call if the account’s equity balance remains above the margin used.

CFD brokers no longer phone you first in the event of a margin call. The platform flags the warning; the terminal turns red, for example, and if things get worse, it automatically starts closing positions. How much worse does it need to be for forced liquidation to occur?

Brokers set two thresholds based on your margin level. The first, as I noted above, triggers a margin call, a warning to add funds or reduce exposure. The second, lower threshold is the stop-out (or close-out) level, at which the broker begins closing positions – usually starting with the largest losing position – to help protect itself (and you) from further loss. This is generally a 50% stop-out level. For example, with US$1,000 of used margin, a 50% stop-out level means positions start closing when your equity falls to US$500.

Bringing it all together

Margin is not the enemy, and leverage is not something to fear. Both are consequences of the risk decisions you make. Control your risk per trade, size your positions based on your stop distance, and keep a buffer of free margin. I purposely kept the final words simple, because once you understand the mechanics behind margin, it is simple. If you would like to explore the world of CFD trading, open a trading account with FP Markets and start building your trading plan today.