Margin trading or trading on margin is the most important concept you need to understand about financial spread betting.
When you invest in a share or a tracker fund, you have to provide the full outlay of capital to buy into it.
However, margin trading allows you to trade shares and indices but you only put up a fraction of the cost. Spread betting usually works on the basis of you putting down 10% of the total value of the trade.
Now if you’re bet is correct, your profits based on the capital you put down will be amplified considerably – because you only put down 10%. But if your bet doesn’t come good, you will have to provide the extra capital as you only put down 10% – the remaining 90% is on margin.
So let’s look at an example on a successful buy / go long trade…
You decide to buy £10 per point on shares in at Ocado at 500p.
The total value of the trade is equivalent to £5,000 (5000p) and the capital needed from you will be 10% or £500 in this case.
Let’s say the Ocado share price increased by 10 points a few days later and you decide to sell up at 510p.
Therefore, you would be in line for a profit of £100 (£10 per point and the share price increased by 10p or points).
As you only funded 10% of the total value of the trade, your return on your outlay is a rather impressive 20% (£100 back on £500).
What would have happened if the trade was a bad one
Taking the above example to the opposite extreme. Let’s presume that the buy bet you placed on Ocado didn’t come good. Infact, Ocado went bust and it’s shares were worth nothing.
Had you invested directly in £500 of Ocado shares, your loss would be limited to £500. But as the hypothetical price fell to 0, your bet will see you lose more than 10% of the trade you put down (the £500), it will see you lose £5,000 (the drop from Ocado shares from 500p to 0 at a price of £10 per point).
Managing your risk
Trading on margin is essentially a catch-22, you enjoy higher returns from a limited outlay, but you will also suffer losses way beyond your outlay when things move against your bet. Luckily, like with investing, you can also use stop-losses in financial spread betting too!