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Each trade that you initiate has a value. One of the advantages of financial spread betting is that you do not need to put up the full value of the trade to open the position. The amount of money you do need to open the trade is known as 'Margin'. Each trade has a 'Margin Requirement'. You may have read or heard that you can begin spread betting with as little as £10. This is simply not true since all spread betting companies require a Margin 'deposit' for any trade to be initiated.
Margin trading is sometimes referred to as leveraged trading or gearing up)
Each spread betting company's Margin Requirements are different in values but similar in structure. They are often worked out as a percentage of the value of the bet or have a fixed amount.
Let's have a look at some examples -:Remember to check exactly what a point means. Typically in the above examples a point on the DOW is 1 index point - a point on a U.S.A. share is 1 cent and a point on gold may be 10 cents. Please read your manual carefully and, if you are in any doubt, contact the Help Desk or consult the On-Line Dealing Manual.
As can be seen from the above examples, trading on margin enables you to open a position without 'putting up' the full value of the bet. This is what is known as leverage, i.e. you get the effect of the full value of the bet for a limited investment - BUT NOT LIMITED RISK! Please note that the lesser the margin requirement - the higher the leveraged position.
An interesting point to note here is that different spread betting companies treat margin requirements differently once the position is open. For example, some companies will require the margin to be available for the duration of the bet with no regard to the profit or loss situation with your position, so you will always have the same margin requirement. Others will eliminate the need for a margin once the position has become profitable and a stop order has been placed at the entry point of the bet, i.e. you cannot lose any money. Please fully understand the margin rules as laid down by your chosen spread betting company to avoid any nasty surprises.
The dreaded margin call comes when your position has gone against you and you have insufficient funds in your account to fund the margin requirement.
Let's look at Example 1 above:
You are long DOW Futures at £10 per Point. You opened the position when the offer price of the index was at 9500 on quarterly contract expecting the index to rise. The margin requirement is £300 x £10 = £3,000 and you have deposited £3,500 in your spread betting account.
The current index bid/offer prices are 9400/9410, i.e. it is 9400 to sell your position. You have a 'paper loss' of 100 Points at £10 per Point = £1,000. The balance in your account has now depreciated by the same amount and is now standing at £2,900, i.e. you have insufficient margin to cover your position. Your spread betting company will initiate a margin call either by telephone or e-mail asking you to rectify this situation.
There are two actions you may take. Either deposit more funds into your account to cover the margin or close all or part of the position until your margin is sufficient to cover the position, e.g. if you sold at £2 per point you would only require a margin of £8 x £300 = £2,400.
In the event that you do not take any action, then your spread betting company will almost certainly liquidate your position, i.e. close all or part of your position without any further reference to you, and, if your account becomes negative, you would be liable for the balance.
Always give consideration to your bet size relative to the size of your account balance. There is nothing more frustrating than having to take a loss because of lack of margin, and then seeing a few days later that your position would have been profitable.
A word of warning regarding margin trading or trading on margin as its sometimes referred to. Highly leveraged positions can be extremely profitable but can also lead to big losses. Consider this: if you bought £10,000 worth of shares in the traditional manner through a broker and they depreciated by 20% you would have to pay the £10,000 up front and would realize a £2,000 or 20% loss.
Dealing costs, spreads and stamp duty are ignored for the purpose of this illustration. To place an up-bet on the same shares may only require a margin of £2,000 (20%), but if the share price fell by 20% you would lose the same £2,000, which is 100% of your investment!
Margin trading at its most perilous is best exemplified by the tale of derivatives trader Nick Leeson and his dealings at Barings Bank in the early 1990s. Trading on the movement of the Japanese Nikkei index, his losses mounted to £1.3 billion, enough to bankrupt Barings.
While this made-for-movie catastrophe should serve as a dire warning to those who engage in margin trading, it would be unfair to overlook the success stories. Margin trading is not new. Fund managers and banks use it to bulk up or protect their share portfolios. Spread betting, as a form of margin trading, suits those who want to risk a small amount of capital compared to the hundreds of thousands of pounds that fund managers spend.
For example, with spread bets starting from 2p or £1 a point, worst-case scenario losses can be as little as £100. At the same time, those who are more experienced can raise the ante to as much as £45,000 per point.
A simple way of describing the risk is this: If you had a pound in your hand and you bet it on a horse and that horse finishes last, you would have lost £1.
With margin trading, if you bet £1 bet on the FTSE, you could lose £4,000 (i.e. the FTSE index falling from 4,000 points to 0. That will have to be a really bad day!)
The key is for the spread better to calculate the potential losses before they place a bet...Are you comfortable with that level of risk? Can you afford to lose that much?
Be patient. Too many traders new to spread betting try and make it their goal to make us much as possible, in the quickest time period. But this usually leads to disaster because they simply take on too much risk to try and achieve this goal.
Using high level of gearing/leverage is one of the fastest ways to blow your account. The moment I switched to a much lower leverage strategy it has changed my mind-seet on the concept of leverage.
Add to that the possibility of a share dropping by some 10% is infinitely far more likely than the security dropping 100%, so for someone who had bought Sainsburys' stock with leverage at 300p with a 10% stop loss order; if they had bought £12k worth of Sainsburys' stock [equivalent to 4000 shares] with a £1,200 margin deposit (i.e. using maximum leverage with 10% margin deposit) and the next few days Sainsbury were to fall by just 30p they would had had their entire account wiped out, whereas if they didn't gear they would have been £1,200 down while still holding the shares. Of course there are plenty of ifs and buts but I would say that's how most people tend to get hammered.
Which is why it is critical not to use the full margin. Obviously the 10% stop loss level mentioned above is just an example and if the share were to move up by 10% you would likewise have doubled your initial investment but it does help to highlight the dangers of being over-leveraged/under-capitalized. In a real situation you have to plan a trade and stop loss level around a support level and if it were to breach that support level, you have to write off the loss as the cost of business.
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