Trading on margin sounds appealing, especially to undercapitalized traders who do not have the wherewithal to invest enough for a decent return. The more margin you use, the bigger positions you can assume, which ultimately means an opportunity for higher payouts.
That being said, most people neglect the other side of taking a trade. The potential losses on a margin trade can also blow your account up in a short amount of time. Here are tips on how you can avoid that:
Know Your Costs
Interest rates, for instance, can bite a huge chunk of your trading capital. Depending on what asset and broker you choose, the interest rate will vary. For instance, in futures trading, the margin required to open a position is a fixed percentage that ranges between 3 to 12 percent of the contract’s notional value.
Commission fees are another big cost that a trader usually pays to open or close a position. Unchecked, these costs can gradually reduce your account size and make it difficult to bounce back from losses.
Buy in Small Increments
Opening positions in smaller increments rather than buying all at once can help protect you from massive losses incurred from sharp price turns. Financial markets can and will behave erratically at times.
If you enter 100% of your position on the first order, you can end up losing more money in the event of a sharp and immediate price change in the opposite direction. Try to enter the market with 30 to 50 percent of your position and then incrementally add to it as the price moves in your favor.
Set a Stop Loss
According to SoFi, learning how to margin trade effectively should revolve around sound risk management practices, one of which is to always set a stop loss. A stop loss order essentially tells your broker to close a position when the position hits a specific price.
This ensures that your losses do not exceed a certain predetermined dollar amount and lets you automatically close a position without having to manually monitor the trade.
Have a Plan
In trading, the most sophisticated strategies don’t always equate to the most profitable outcomes. Avoid blindly copying someone’s trades or systems without understanding the reasoning or strategy behind them.
Stick with a simple plan that is enforced with sound risk management rules. Rather than speculate, stick with proven metrics, including price-to-earnings ratio, free cash flow, and dividend yield.
Avoid Trading Every Minute
While many traders, also known as scalpers, are able to profit on trades that are open for as short as a minute, the long-term probability of you coming out profitable is low, not to mention the stress involved in having to do it, again and again, every day. The longer the time frame, the less erratic the price can be.
Margin trading can be a lucrative venture if you play your cards right. Use only a small percentage of your capital while coming up with a trading system and risk management plan that works before you start trading big.