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Dangers of Margin Trading and Very Short-Term Trading

Dangers of Margin Trading
Written by Andy

In recent years margin trading has gained popularity as the trading platforms that were once available only for professionals can now be installed and used by small investors. A growing number of financial institutions, mostly in Europe, now offer margin trading in so-called contracts for difference (CFD). You sign a contract with them, deposit the money to your margin account, download the application, and you can start trading.

About a year ago ASIC (the Australian Commission) conducted some research into the CFD market and what we found was concerning. Quite a number of investors do not understand the workings of CFDs. Many believe they are buying the underlying stock when in fact they are buying a derivative. You see, when you buy a CFD through a market maker you are not directly involved in a stock market transaction. As far as you are concerned, you are trading against the institution providing the platform. What do they do and how to they hedge is of no direct interest to you. All you need to know is that there is always a ready market for you as you can open or close your position almost immediately.

Practicalities of Margin Trading

CFDs are usually advertised as mechanisms enabling you to take both long and short positions without having to deposit the full amount that you are trading. With stocks, you typically can get a leverage up to factor five, which means that you have to deposit at least 20% of the traded amount – with $20,000 in your margin account you can enter positions with nominal value of up to $100,000.

Let’s say that you have $25,000 in your account and that you have opened long position for $100,000. 20% of this amount, or $20,000, is used for margin, and the remaining $5,000 minus the transaction costs you paid are visible on your trading screen as “available for margin”.

Margin requirement obviously oscillates with stock price. If the stock drops 4% the nominal value will be $96,000, which means that your minimal deposit will be $19,200, and if it goes up to $104,000 your deposit will have to be $20,800.

You take the full loss or gain on the position. In the above example, you will have to pay for the loss of nominal value of $4,000, and what is 4% loss in the stock price translates to 20% loss of your $20,000 deposit. Instead of initial $25,000 you will have less than $21,000 on your account.

The problem starts when your amount available for margin drops to zero and the stock price continues to move south. You get in the situation that the amount required for margin is more than what you have in your account, and you receive a ‘margin-call’ from your institution. This means that you either have to add more money to your account, or to close your position. In the above example, if the stock price would drop 7%, nominal value would be $93,000 and you would have a loss of $7,000. Your total amount would be $18,000. However, to keep the open position for $93,000 you need 20% of this value, which is $18,600 – more than you have in your account – so you would receive a margin call.

Risk Management

Speculators have come up with various trading rules designed to prevent this from happening and increase chances of success. One such rule, often publicized, is never to use more than 60% of your deposit for margin requirement and to keep 40% available for margin and therefore accommodate greater volatility. While this is without a doubt better than going close to full margin and get called out after a small stock price move, it implies that you are willing to tolerate up to a 40% loss on your account.

The other rule is a variation of the old Wall Street axiom that you should cut your losses early and let the profits run, so as soon as you see that you were wrong, you should close the position. The same way you would close the losing position in stock if it drops 8%, you would close it in CFDs, without amplification by margin – if you have $20,000, you can tolerate to lose no more than $1,600. At this point you close the position, take the (limited) loss and think what to do next. (What does ‘early’ mean and how much can you tolerate is relative, but 8% is chosen as a reference point).

This is not as simple as it sounds and to illustrate this let’s take a look at a practical example with contracts for difference in shares of Caterpillar Inc. (NYSE:CAT). This is a large cap stock with decent trading volume and anything that can go wrong here can only be worse with smaller and riskier stocks trading at higher spread. At one point of time the bid and ask for this CFD were $76.052 and $76.178, respectfully. To buy a CFD equivalent of one thousand shares you would need to meet margin requirement of $15,263 with the nominal value at ask being $76,178 (margin requirement for this stock is 20% of nominal value).

Cost to open the position is $76.13 and to close it is another $76.01. Spread between bid and ask prices in nominal value is $126. Therefore, if you could open and immediately close the position you would lose $278.14 without any stock price movement. This represents 1.83% of your margin requirement, which can be considered your de facto investment. So, you start your position at -1.83%.

Let’s assume that financing interest charged for holding this position is $16.93 day and let’s imagine that you hold it for one week, and that makes it $118.51.

So, in one week, even if the stock price does not move at all, you lose $396.65, or 2.6% of your investment. To break even the nominal value has to rise for this amount, which means the stock price has to go up 0.52%.

Now let’s look at what has to happen for you to gain or lose 8% of your investment. 8% of the required margin deposit is $1,218.88.

You have already lost $396.65, so we need to determine how much should the stock price go down for you to lose another $822.23, and the answer is 1.08%. At the same time, to gain 8% you need to make $1,218.88 + $396.65 = $1,615.53 and this would happen with 2.12% rise in stock price. These percentages are obtained by comparing these amounts to the nominal value, but can also be seen from the fact that 20% margin requirement means factor 5, so 8% gain of loss in investment compares to 1.6% gain and loss in stock price, with additional 0.52% for initial loss when taking position.

Any investor knows that the short term price movements in this range are quite random. No matter how good you think you are, it is very hard to predict stock market price movements of such a small amplitude. Basic stochastic laws work against you as for quasi-random distribution centered around a certain value, smaller changes (both positive and negative) are significantly more probable than larger ones. Think of the Gauss or bell-curve in probability. Another way to look at this is as if it was stock trading with stop-loss at 1.08% below the price. Such trading has a very high failure rate as such small movements are unpredictable.

For 10% it is 1.48% and 2.52% and for 20% these values are 3.48% and 4.52%. With greater percentages probabilities are more equal, but always biased against you.

If you would hold this position for a year, you would have to pay 365 x $16.93 = $6,179.45 in interest, so your loss – without any stock price movement – would be $6,455.61. This is 42.37% of your initial requirement and equivalent to 8.47% movement in the stock price, enough to neutralize the natural positive bias (in average and over time stock prices do go up and S&P500 moves in average 11% per year, but it does not take into account that some of the worst performing stocks lose capitalization and drop out from the index).

In summary, if there was no danger of a margin call you would in average in the long run most likely have the same amount that you started with. However, a relatively small drop in stock price can trigger your stop-loss or margin call, so the probability of losing money is greater than the probability of making money. Simply, although contracts for difference are a viable trading instrument, trading on a very short-term basis is likely to work against you and is best avoided.

Obviously someone does profit from this trading but this is a zero-sum game and most investors end up losing money. As regards the institution: You have to pay to open and close the position, difference in bid and spread and interest, and it all goes in their pockets without any risk. As mentioned above, the moment you reach your maximal exposure you will receive a margin call forcing you to add more money or take the loss and close the position, so the provider that allows you to trade on margin has no risk whatsoever.

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