What is Trading on Margin?

Trading on Margin

Normal trading vs Spread Betting

When you trade shares in your normal trading account, you will generally deposit the money you want to invest into your account, and then 'spend' it on the shares. For instance, if you wanted to buy £10,000 worth of Barclays shares, you would deposit that £10,000, look up Barclays price (roughly £3.20 at the time of this article), and buy as many as you can afford. In this example it would be - £10,000 / £3.20 = 3,125 shares. 

Your liability, or risk is £10,000 - that's what you invested. That's the most you can lose.

The Spread Betting Equivalent

With Spread Betting, you are not actually investing in the shares - you are betting on their movement - putting up a 'bet' per point movement in the share price (a point being a penny in this case). Spread Betting companies will offer you a trading 'margin' - which means that they do not require you to have all the money you are risking. If you were to take a Spread Bet position equivalent to the above Barclays example, it might go as follows:

  • Your exposure, or position is calculated as (bet in £  x  share price in pence)
  • To take a calculate a bet equivalent to £10,000 Barclays shares, you would do £10,000 / 320 points = £31.25
  • So , you bet £31.25 per point on Barclays to rise from a price of £3.20
  • And therefore, your exposure (risk) is £31.25 x 320 = £10,000

However, while your position is worth £10,000, your spread betting company will not require you to put down the total - merely 10 or 15% - so you would only need £1,500 in your account.

Who Lent you that Money?

That means that someone has effectively lent you £8,500 - and that someone is your spread betting company. To put it in the cold light of day, with £1,500 in your spread betting account, you can bet or gamble £10,000 mostly on borrowed money. It's a sobering thought - are you confident enough in what you are doing to take an £8,500 loan to back up your bet?

Worked Examples - Potential Gains

It should be clear that trading on margin has some serious risks, but also some serious advantages. In the normal share trading example, if you invested £10,000 in Barclays at £3.20, and Barclays goes up to £3.50 you calculate the profit as such:

  • (£10,000 / £3.20) x £3.50 = £10,937.50 
  • ... or a profit of on your investment of £937.50 (just under 10%)

With the Spread Betting example, you have bet £31.25 per point at £3.20 and the profit is calculated (roughly) as such:

  • movement = 350 - 320 = 30 points
  • 30  x  £31.25  =  £937.50, or a return of approximately 62% on your investment of £1,500.

In the spread betting example, you can see a massively higher return on your investment - 62% instead of 10% in the first example. Why is this possible? It's because of the risk.

Worked Examples - Potential Losses

Lets do the example the other way.

With normal share trading, you invest your £10,000 in Barclays at £3.20 - Barclays has a hard time, and falls to £2.60. It's a big drop, but perfectly possible (between December 2012 and Feb 2013 Barclays rose from £2.50 to £3.20).

With your normal account, your loss is calculated as such:

  • (£10,000 / £3.20) x £2.60 = £8,125 - or a loss of £1,875
  • That's an 18.75% loss - but only if you sell.

If you were confident that this was only a blip with Barclays, with your share trading account you can wait it out. The investment is still worth £8,125 to you, and there's a good chance it will bounce back. Of course, you could decide that the loss is enough, and you stop it getting any worse by selling, and taking your £8,125 out - but that's up to you. 

With the spread betting account, it's a little different.

  • movement = 320 - 260 = 60 points
  • Your loss = 60 x £31.25 = £1,875

But hang on - you only had to have £1,500 in your account to place that bet - you've not lost 18.75% as above, but you've lost all of your money, and some - 125% of your investment. Your spread betting company will now be on the phone asking you to deposit more money to cover the loss and keep the position open - otherwise they will close the bet (solidifying the loss), and bill you for the difference - £375, if you're lucky. This is called the 'margin call'.

As you can see, there are some massive advantages of spread betting vs normal trading, but also some massive risks. It's no suprise that many, many more people lose at spread betting than win - but if you manage your risk carefully, it can be a powerful tool. A good rule of thumb is to never place a bet without first calculating your total risk, not just for that position, but if all of your positions go bad. Another good rule is to always set a stop order to protect your position from getting too painful - ideally a guaranteed stop, although that will generally cost a bit more.