Margin Trading And Maintenance Margin: Explaining Leveraged Trading
With collateralised accounts, traders have the ability to execute sizable trades. Merely by depositing more money, they can still buy stocks even if there is not enough money in the account. Their outstanding borrowing is settled with the financial support of the broker. Trading with leverage can enhance the value of a position, but it also involves inherent risks. Thus, traders could be obligated to pay the broker a sum that surpasses their account funds. This article explains what margin accounts are and how maintenance margin works.
Explaining Margin Accounts
Leveraged trading is a strategy where investors borrow money from brokers to explore high-value market positions without having enough cash in their accounts. However, this approach is considered risky as it could lead to indebtedness and account liquidation if not managed properly. To secure the variable margin, proper planning and calculations are required.
Leveraged trading involves using a broker’s services and borrowing money to explore high-return positions in the market, often used by traders with limited equity to capitalise on market opportunities.
Let’s have a look at an example. A trader, anticipating an increase in Apple’s stock price, plans to purchase 100 shares at $200 each, but with only $1,000 in their account, the market order will cost at least $20,000.
The trader can use their leveraged account to offer 1:20 leverage, multiplying their $1,000 balance by 20 and executing a market order at $20,000.
Explaining Maintenance Margin
Maintenance margin, also known as variation margin, is the capital required to maintain a leveraged trade, ensuring sufficient funds to fund the position’s present value and cover any running losses.
The variation margin is a prerequisite for opening a margin trading account, requiring a trader to maintain a minimum equity amount to serve as a guarantee for the broker.
The variation margin is the trader’s account credit required to maintain their leverage trading position, a risky strategy preferred by risk-takers for unique trading opportunities resulting in substantial returns.
The variable margin is determined by the broker’s rules and guidelines, using the collateral as a way to show how much funds are still available before margin calls and the trader’s capital needed as a percentage of the total margin in the market order.
The investor must maintain the variation margin, and if the market moves sideways and the open position loses value, the broker will issue a margin call once the balance drops.
A margin call is a request to increase funds in a margin account to maintain a leveraged trading position and prevent a negative balance, while brokers may close or liquidate assets to prevent excessive losses.
Calculating Maintenance Margin
Your account balance is determined by factors such as the money borrowed, your available funds, trading volume, and broker rules. Using margin in trading carries the risk of owing money to the broker and being liable for any losses. This strategy is well-suited for traders who are comfortable with risk and have significant capital to reinvest in case of losses.
FINRA has determined that traders must maintain a margin of 25% of the total value of securities in their account.
The maintenance margin requirement serves as a risk assessment tool, indicating the trade proposal’s risk and potential market unfavorability, necessitating thorough calculation and analysis before any trade proposal is made.
The following formula can be used to calculate the required variation margin amount accurately:
Variation Margin Level = (PA * AEP * VMR) + AACP
Where:
PA is the position amount;
AEP indicates the average entry price;
VMR is a variation margin rate;
ACCP means assumed commission for closing the position.
Yet, a trader may calculate the average position value using another formula:
Average Position Price = TCV / TTA,
Where
TCV is the “Total contract value”, and TTA means the “Total transaction amount”.
Calculating Margin Call
A margin call occurs when a leverage trade’s value drops and the variation margin amount is reached, requiring the investor to add funds before the position is liquidated, with the margin call price calculated accordingly.
Margin Call Price = P0 (1 – initial margin / 1 – variation margin),
Where P0 is the initial purchase price.
Trading with leverage involves unique considerations and broker requirements, so it’s advisable to consult with the broker about margin elements, calculations, amounts, and collateral before engaging in leveraged trading.
Conclusion
Trading with margin trading implies borrowing funds from a broker to increase trading volume and potentially earn higher profits in the stock market. Nevertheless, if the market performs poorly, there are greater risks applied to this strategy, which may result in the broker accumulating substantial debt.