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A brief excursion to the world of margin trading

08/24/2018
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  • trading
  • for beginners
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Everyone is familiar with the word “broker”. You can encounter it in different spheres of life, basically, it means one thing – an intermediary. There are customs brokers, stockbrokers, insurance brokers, mortgage brokers, etc. These are absolutely different professions, but they have one thing in common: all of these specialists (or their companies) are addressed for a ready-made solution of a whole complex of tasks, which are hard to handle for outsiders. Thus, a mortgage broker will lead you through the whole procedure of finding a mortgage loan: he or she helps you prepare the required set of documents, finds all of the banks’ offers and finally connects you to your new home for the lowest rate. A customs broker charges itself with all the documents required for goods import and export, etc.

Stockbroker. What is it for?

This article will navigate you through a stockbroker’s features and duties. A stockbroker is a company that helps clients make deals on stock exchanges and purchase or sell goods, commodities, shares and speculative instruments, such as options or other contracts, all of which do not imply actual delivery of goods from buyer to seller.

And though brokers (as any intermediaries) are not among everyone’s favourites, only THEIR MONEY gives people access to the most profitable markets

Speaking about the contracts made on stock exchanges, they are made for quite large amounts of money. For instance, take FOREX – an international market of currency exchange. It is not bound to one particular exchange, so it is not controlled by any particular regulator, yet it is one of the most important and powerful trading platforms in the world. The minimum Contract Size available is usually 100’000 USD. Looks like ordinary people, not big cats of finances or their children, simply can’t have access to FOREX market. But this is not true. Thanks to stock brokers, almost every person can use his or her spare funds to invest into buying or selling currencies.

How does it work?

First of all, brokers that have all the necessary licenses provide access to trading to their clients, usually individuals. Brokers also give the amount of money necessary for completing a deal – leverage. This is how, having some funds on their accounts, brokers’ clients can make multi-million deals.

All of this is possible with margin trading

Let’s look closer into leverage: it means a system of levers, tools that help individual traders “take” the contract size that is hundreds of times larger than their own funds. Leverage shows the proportion of client’s funds towards broker’s funds. For instance, leverage 1:100 means that a deal would involve 1% of trader’s funds and 99% of broker’s funds.

Here’s the core of it

Leverage should not be compared to the conventional bank loans, it has its own special work principles. The funds are borrowed only for the period of a deal, i.e. purchasing or selling a contract, a currency or any other instrument. Surely, brokers don’t want to risk their money in clients’ lost deals. This is why every deal places certain requirements to a client’s account. Thus, with 1:100 leverage and contract size of 100’000 USD, 1’000 USD come from the client’s account and 99’000 USD – from the broker.

Obviously, the latter will avoid losing its funds by all means. This is why with every transaction a part of trader’s funds serves as a pledge for the period of this deal. This pledge is called “margin requirement”, and this is where the name “Margin Trading” came from.

Losing deals are active as long as a trader has enough funds on his or her account to provide this margin requirement. As soon as the amount of funds lost in a deal reaches the pre-specified level, say, 20%, then this deal is closed automatically to prevent loss of broker’s funds. This unpleasant feature is called Margin Call.

If a deal is a success, then the broker’s funds, in other words, leverage, go back to the broker, while the margin requirement goes back to the client with all of the profits.

What is the broker’s benefit (and what’s the catch)?

Brokers earn on commissions paid for every deal. For traders these commissions are insufficient, taking into account the amount of leverage and potential profits.

Does it really work?

And now we came to the best part of it: how do people earn on FOREX, commodities and shares? The ever-increasing interest towards online trading is easy to explain: it’s a real opportunity to earn a lot of money within a short time.

We have to bear in mind that in some terms this money is made out of thin air. Contracts made by individual traders do not imply actual delivery of traded instruments, whether they are different currencies, shares or commodities. This income is speculative and is derived from the difference in “Bid” and “Ask” prices.

This is the main feature and the main advantage of margin trading. You can earn on both increase and decrease. If the price for a trading instrument goes up, traders open orders to purchase the instrument and then close these orders when the price is higher. On the other hand, if the prices go down, then a trader can open a selling deal for a higher price, close the order with a lower price and, again, earn on price difference. It’s simple: prices go up – buy, prices go down – sell.

This is a purely speculative income. Making profit requires traders to be good at analysing the market trends, following the fundamental news, having a good trading strategy, using money management techniques, etcetera, etcetera. This is why inexperienced traders often bear losses.

Today everyone can find a lot of information about trading online, in specialised textbooks or on training sessions in numerous dealing centres. Also, the majority of brokers provide free demo accounts, where one can train their trading skills with virtual money. This is not a lure, not a marketing instrument. High potential profits of this type of investment imply high risks as well. This is why professional traders always use at least 4-5 demo accounts to test their strategies and polish their trading skills.

I want to leave you with a little guidance

Remember, there is no such thing as easy money. You need to work hard to have better results. Constant development, good analysing skills, finding and correcting your mistakes – this is what builds one’s success in trading. It is also very important to find the right “trading partner” – an exchange, a broker or a platform where you make your deals. What is the quality of services (trading software, support, etc.)? Will your deals be processed instantly? How transparent are the commissions and other charges? So many things depend on them!

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