Using margin – a double edged sword
Having the ability to trade on margin is a powerful leveraging mechanism if it used correctly – but one MUST also be aware of the potential dangers. The greater the margin that is afforded you through your brokerage, the greater the potential damage one can unknowingly do their capital. Lets take a look using the m3 – Money Management Modeler. The reason I chose this topic to blog about was due to a client of mine who had requested that I expand the margin levels from the standard 2x that I had built into the platform. He requested that I allow for 10x margin! I shook my head in disbelief but I made the changes changes as per his request – I’m just not so sure this particular client realizes how damaging that could be to his account balance should the trade move against him. Below is a screen shot of a hypothetical trading account with a start value of $50,000.
m3 - Money Management Modeler - the risks of margin
http://www.screencast.com/t/NjFlNTk3NmM (Click to enlarge)
In the screen shot about one can clearly see the advantages of trading on margin. In this $50,000 account example, the 3:1 leverage provides a trader with $150,000 purchasing power. That’s great if the trade goes in your favour – not so great if you have utilized that available margin and it is a losing trade. That’s why margin is called a double edged sword – it cuts both ways. Brokerages are all too happy to provide you additional funds to trade with. The will obviously reap the benefits twofold – 1) they charge interest on those additional funds they are providing and 2) more importantly they collect additional commission fees because of the increased position size of the trade you are now able to make. This could be on one LARGE single trade using the margin, or over a basket of smaller positions . Either way the additional trading capital which is made available when used, generates additional revenue for the brokerage and the best part from their (the brokerage) perspective is the fact that they can liquidate your holdings at any time if the positions that you entered on margin begin to move against you. This is known as a margin call and trust me – they are not fun. Risk management and position sizing trump any margin made available to today’s trader EVERY TIME. With a tool like the m3- Money Management Modeler, over trading or taking on a single position that is too large relative to your risk just doesn’t happen unless you consciously choose to ignore the results that the platform produces. Used correctly in the right hands and with the right tool, margin can be a POWERFUL leveraging mechanism to rally your account balance at an accelerated pace.
Fulcrum Shift Trading
Tags: margin trading, position sizing, risk management