Gearing, Margin Trading and Leverage

Q.: What is Margin?

A: CFD trades are margin-based transactions. Margin refers to the deposit the stock market trader must provide in order to open a position. For instance, if Barclays has a margin of 10%, the client can pay 10% of the total market position value while borrowing the remaining 90% from the CFD provider. In other words, the trader entering a contracts for difference trade is only required to put up a fraction of the total value of the specified contract traded. Margin money is essentially a guarantee that the person (trader) will honor the contract entered into with the broker. Margin is set based on risk and on what it would cost to buy the investment for its full price. By trading on margin, the trader can acquire a larger exposure to a particular stock for a reduced amount of money.

Margin is thus the minimum deposit you are required to make by your CFD provider so you can open your CFD trade. Your risk level will depend upon your margin covering your margin trade. The amount required to initiate a new position (i.e. enter a trade) is referred to as 'Initial Margin'. Initial margin is usually set at a percentage of the value of the contract being traded. The Margin is set by the CFD provider.

Note: When you have calculated your initial margin payment, you will need to ensure that when you place a trade you have sufficient money on your trading account to cover it. Note also that if your position starts to lose money and you do not have sufficient money in your account to cover the loss, you may also have to pay ongoing margin.

Q.: But why does a broker require you that you deposit a margin payment?

A: Well, the detail of it goes on something like this -:

It has probably happened to you more than a couple of times that as a result of taking a bet from a friend or co-mate, you end up being owed an expensive bottle of champagne but never end up receiving your due...

This is cited to as credit risk in banking terms. If an investor buys a leveraged share CFD with a broker, it can only result in three possible outcomes:

- 1. Both parties owe no cash. You are happy. The broker is happy.

- 2. The broker owes you money. You are happy. The broker is unhappy.

- 3. You owe the broker money. You are unhappy. (but do you have the cash at close hand to pay the difference?) The broker is unhappy as it has now effectively lent the investor money without even knowing whether you are able to honour your liabilities and may need to resort to court proceeedings to recover payment of its debt.

This problem is solved by the broker requiring a margin payment from every investor that wishes to trade in share CFDs. The risk management from the broker's point of view is determining what the margin rate should be for the market under consideration.

There would be little basis for requiring an investor to deposit a full 100% margin for the underlying financial instrument, as the investor would then be better off buying the shares outright via normal shares dealing (and they wouldn't incur daily financing charges). But of course a 0% margin isn't possible as the broker would then have no protection. The correct answer would be somewhere in between with the margin rate being determined mainly by the liquidity and volatility of the financial instrument. Generally for blue-chip stocks (i.e. stocks quoted on main indices such as the FTSE 100, Dow..etc) margin rates can be 10% or less.

If an investor breaches his margin requirements, the broker would simply alert the client and if necessary close out a few or all of the positions to ensure the investor remains within his margin requirements. This logically requires the broker to have a good trading platform with a solid infrastructure in order to manage and control this hidden credit risk.

Q.: What is Initial Margin?

A: Initial Margin refers to the initial deposit required to open a position. For UK share CFDs, this ranges from between 5% to 50% of the whole notional value of the position. Thus, if you purchased 10,000 ABC CFDs at $1.45 and assuming a 10% initial margin deposit, you would be required to have not less than $1,450 within your account to cover the minimum margin requirement (10% of your total position size of $14,500). The margin requirement for index and forex CFDs is often as little as 1%.

Q.: What is Maintenance Margin?

A: It is important to note that the value of all contracts for difference positions is constantly being monitored and re-assessed by brokers. As a trader an important part of the contract is that you must agree to maintain the positions at the required deposit value on an ongoing basis.

Maintenance margin also sometimes referred to as variation margin is the amount of margin that is needed to maintain a position (remain invested in a trade). Initial margin is always higher than maintenance margin, so for as long as the initial margin is covered you do not have to worry about the maintenance margin. Usually, maintenance margin is about 75% of initial margin. When the available monies in your margin account are reduced by losses to below a certain level, known as the maintenance margin requirement, you will be required to deposit additional funds to bring the account back to the level of the initial margin. Or, you may also be asked for additional margin if the exchange raises its margin requirements.

Variation Margin refers to the difference between the initial margin and the margin needed to keep the position open as the position value changes. For instance, if the initial margin for gold is $2,000 and the maintenance margin is $1,500, you would need to have $2,000 allocated from your account as initial margin to trade the gold contract. Positions are marked-to-market every day meaning that every position is valued at the close of each business day with any profits credited to your trading account and losses deducted. This means that the current price is compared to the previous day's price and should losses on the position amount to, say, $600, the value of your initial margin would be reduced to $1,400, which is below the $1,500 maintenance margin requirement. Therefore, extra funds in the amount of $600 from your account would be automatically allocated towards bringing the initial margin figure back to $2,000. If there were not excess funds in the account to bring the initial amount back up to $2,000, the trader would have to meet the margin call promptly as otherwise the position would be liquidated by the broker which means having your investments sold by the provider because you can't meet the margin top up requirements.

Variation Margin Share Trade Example

Let's take the case where you bought 5,000 share CFDs in ABC stock at $4.20 giving you a total position value of 5,000 x $4.20 = $21,000. Assuming an initial margin of 10%, you would need to deposit at least $2,100 with the CFD broker to open this trade. If ABC's share price goes down to say, $4.10, you will now incur a loss of $500 ($0.10 x 5,000). This running loss referred to as variation margin is subtracted from your initial margin of $2,100, which leaves a deposit of $1,600. Since you still hold 5,000 share contracts at $4.10 you will have a margin requirement of $2,050 (i.e. 5000 x 4.10 x 10%). Since there's now a paper loss of $500, the initial margin has now been reduced to $1,600 which is $450 lower than the margin required to retain the position open and more margin is needed to top-up the account. This deficit in margin is sometimes referred to as a 'shortage in equity'. If you cannot maintain the margin requirement you will not be able to extend your position but you can always reduce or close the position.

Q.: What is a 'Shortage in Equity'?

A shortage in equity happens should the account balance falls below the required initial margin level. Accounts having a shortage in equity are usually only permitted to reduce open positions, until the equity balance is in more than the required deposit. No new positions can be opened until this situation is sorted out.

Q.: What is a Contingent Liability Transaction?

A: Contingent liability investment transactions are margined transactions like contracts for difference which require you to make a series of payments against the purchase price, as opposed of paying the full value of the contract immediately. If you trade in futures, contracts for difference or sell options you may sustain a total loss of margin you deposit with your broker to establish or maintain a position. Should the market move against you, you may be called upon to pay the additional margin at short notice to maintain the position (commonly known as a margin call). If you fail to do so within the time required, your position may be liquidated at a loss and you will be responsible for the resulting deficit.

Q.: What is gearing (or leverage)?

A: Hedge funds use it, so do a number of exchange-traded and investment funds. Daytraders too. Leverage (or gearing as it is sometimes referred to) is much like borrowing: it allows you to increase your potential return on a trade as you increase your exposure to the market.

Gearing, as in the mechanical sense, is the process of turning a small effort into a large output (examples: in a lever or in a bicycle's gears. In financial terms gearing has the same effect: it enables a customer to trade a position in much larger size than the margin that is deposited with the CFD broker, e.g. For an initial deposit of £1,000, a customer can buy or sell £10,000 of a FTSE 100 share (This is 'gearing' or leverage of 10:1). Gearing when used this way is also sometimes referred to as investment gearing.

Gearing in CFDs enables traders with a small float to make good profits from trading the stock market. In other words, gearing or leverage magnifies investment returns and can even help you diversify a trading portfolio as it frees up capital which can then be deployed in other investments. For instance your trading system might be designed to make a 25% return per annum. With a $5000 float, this would produce $1500 in profit in one year. However with CFDs because of the gearing the same system could potentially make a 300% return, which would be $15 000 profit in one year. But it is important to understand that gearing (leverage) is a double-edged sword and an asset can fall as well as rise thereby potentially magnifying your losses.

Q.: Do all CFDs have the same level of leverage, what is the leverage?

A: No, it varies widely - depending mainly on the volatility and liquidity of the underlying markets. Initial margins can range from as low as 1% to as high as 75% depending on the specific instrument. Most share CFDs in the ASX 300 and FTSE 100 are around the 5% or 10% mark whereas for small caps the initial margin requirementd would more likely to be in the 25% to 50% range. If you are looking at foreign exchange then you can get much higher levels of gearing (normally starting at just 1%) simply because stocks are much more volatile whereas a currency moving high in value in a short-time period is relatively unlikely; although it has happened recently with a number of currency pairs so it very much depends on the product that you are trading. Likewise for the indices margins start at 1% of the overall exposure. A number of CFD providers also use a margin-based system wherby the margin required would depend on the stop loss level; so while a trader buying one CFD on the Dow might normally have to put up $350 as margin, the margin required for this same position would go down to just $100 if a 100-point stop loss is built into the position.

Q.: What is NTR?

A: NTR stands for Notional Trading Requirement and refers to the amount of deposit to support an open position in addition to any losses.

Q.: What margin is required for a CFD?

A: The standard margin is 10 per cent of the contract value. A contract for difference with a contract value of $10,000 will require a margin/deposit of $1000 (check with your CFD broker for other margins).

Q.: Why do margins vary?

A: Liquidity and volatility of the underlying security dictate margin.

Q.: Just wondering what the effect is in comparison to small leverage say 3/1 and then more 5/1 10/1 and more.

How does it effect your position in trades? Also, what the difference is in how one reacts to the high gearing situation, much more risk I know.

A: In forex, if you are using 1:1 leverage , and your trade moves 3%, your account will go up or down 3%. With 5:1 leverage , when your trade moves 3%, your account will change 15%. With 10:1 leverage, your account will change 30%.

If you do not want to use leverage and only want to use 1:1 then your position size should not exceed than what the balance of your account is. For instance if you have an account balance of $10,000 and you make a trade for $10,000 then you are not leveraged.

The way high gearing effects traders is the emotional reaction a trader has because such a large percentage of their account is on the line. Greed and fear are the usual reactions.

How this applies to the technical aspect of the trade is that to follow proper money management , you will be forced to really tighten your stops. Higher gearing (i.e. leverage) means a bigger position size. Which follows that to keep your maximum loss of say 2% per trade, you would need to place a really tight stop. But it is important that you do not place a stop loss just because that point is where you are not prepared to risk more money. You first need to make sure you are looking for a support level and then decide on the amount of money you are willing to risk or lose if you make it to that level and lastly set your share size accordingly. Make sure you don't just pick a spot and say 'well here I will be losing $500 so I need to make that my stop loss '.