Know The Risks In Margin Trading

Foreword from ShareInvestor

This article “Know The Risks In Margin Trading” by Aaron Low was first published in The Straits Times (INVEST) on 12 May 2013 and is reproduced in this blog in its entirety.

Novices, steer clear of leveraged products; seasoned investors, here are five pointers

Margin trading has become an increasingly popular way to trade stocks and shares among others.

It allows an individual investor to trade a large amount of stock with a much smaller capital base. This is because the investor is essentially borrowing money to trade the security.

In plain vanilla stock investing, an investor with $1,000 can buy only 1,000 shares of $1 each.

But with leverage of, say, 10 times via margin trading, the investor can now buy 10,000 shares of $1 each. This allows small investors to take large positions that they otherwise would not have been able to afford.

The other attraction of such products, including contracts-for-difference (CFD), futures and warrants, is that investors can “short” the market, allowing them to profit even when the market falls.

But such products also mean that risk is magnified. If the investor’s 10,000 shares of $1 each drops by 1 per cent to 99 cents, his paper loss is actually 10 per cent.

Some financial analysts disavow such products, saying that they tend to lead to investors biting off more than they can chew.

And for new investors with little or no trading experience, such leveraged trading products are certainly not recommended.

But for more seasoned investors who want to take a punt at trading such products, here are five things that they should pay attention to.

Manage Your Risks

The Oracle of Omaha, Mr Warren Buffett, once said: “Watch the downside and the upside will take care of itself.”

Nowhere is this piece of wisdom more applicable than in leveraged trading.

Make full use of stops and limits to prevent your position from running too deep into the red.

But if your position is running well into the black, don’t be afraid to let it run, especially if the trend is clearly on your side.

On the other hand, don’t be afraid to cut your losses early. It’s better to lose a battle and focus on winning the war.

Keep Bets Small

Leverage is sometimes understood as taking on big risks to get huge gains.

That is one flawed understanding of the tool. It’s more useful to understand leverage as a more efficient use of capital.

Because a trader can control large amounts of securities with a small base, this means that the trader can spread out his bets among a wider range of securities.

Likewise, when one opens a position on a security, the position should preferably be a very small percentage of one’s overall capital base.

This ensures that if the market turns against the trader suddenly, his losses will be limited to that small percentage.

Don’t forget that if you lose half of your money, you will need the market to double just to regain your money.

Therefore, it is much easier to lose money than to gain it.

Leave Feelings Out Of It

Losing money is a very unpleasant experience. Often a new trader, when faced with losses, lets emotions dictate his trading decisions.

For instance, when I first started trading, I would get upset with the market if it suddenly turned against my open position in a big way.

As if to take revenge, I would double down, add more to the position and fight the market.

Suffice it to say, I drowned and lost big-time.

Trading, as any professional trader will say, is about making clear-headed decisions, including when to cut losses and get out.

Watch The Reputation

On television, advertisements about online brokers are in abundance. Some offer incredible leverage of up to 500 times.

But often, they are based overseas in countries where regulation is lax.

Singapore’s regulated brokers are a lot more conservative and most offer a lot less leverage.

There is also a real risk that the CFD or futures broker will fail to meet a payment obligation made to you. This could happen if the broker becomes insolvent.

This is known as counter-party risk.

As a CFD buyer, the investor has no recourse to the underlying shares as he did not actually buy the shares.

The spectacular failure of MF Global in 2010 was instructive. The broker imploded as a result of making huge losses on speculative bets, using clients’ money.

Investors who used MF Global managed to get only a portion of their cash back and many lost thousands of dollars due to counter-party risk.

Choosing a reputable broker with strong financials will help to lower counter-party risk.

Use Demo Accounts

Demo accounts are offered on almost all brokers’ platforms and they are an excellent way to get into trading using leverage and to assess your risk tolerance level.

Demo accounts give the user a fixed amount to trade real world prices of securities in a simulated environment.

Before plunging in, all new traders should use demo accounts to find out what it is like to use leverage.

You may lose tens of thousands of dollars in virtual currency over a few days but at least it is not real money.

Demo accounts are useful even after a trader advances beyond the beginner stage.

In fact, some experienced traders still use demo accounts to test out new strategies and trading systems.