On the exchange, you can earn much more than usual if you use borrowed funds. Or – to lose all the money and still remain indebted to the broker. We tell you what an investor needs to know about margin trading and explain the difference between margin trading vs short selling.
What is margin trading?
When answering the question about margin trading vs short selling, it is worth understanding what is the essence of margin trading and its key terms.
Margin trading is a transaction in which an investor takes a loan secured by a broker to buy an asset. The collateral will be own funds in the brokerage account – they are blocked as a kind of insurance deposit. This amount is called the margin. The margin is recalculated each time a trader opens a position.
Two types of margins are calculated: initial and minimum.
The initial margin is the initial margin for a new trade. It is calculated by multiplying the value of the asset by the risk rate.
The risk rate is the probability that the price of an asset will change on the stock exchange. As a general rule, the higher the volatility of an instrument, the higher the risk rate. Regarding margin trading vs short selling please note that the risk rates for short trades are always higher than for long trades.
The minimum margin is the minimum collateral required to maintain a position that you have already opened. Usually, the minimum margin of one liquid asset is equal to half of the initial margin.
To calculate the initial and minimum margin for the portfolio as a whole, you need to add the initial and minimum margin for each liquid asset. If the value of the liquid portfolio falls below the initial margin, you will be able to buy back some of the assets in the uncovered position, but you will not be able to enter into new transactions.
The liquid portfolio is the total value of the currency and liquid securities in your brokerage account.
But if the value of the liquid portfolio drops below the minimum margin, then the broker will have the right to forcibly close part of your positions so that the value of the liquid portfolio does not fall to zero and go negative. The broker has the right to choose positions that he considers necessary to close.
Before closing your transactions, the broker will send a notification about the need to replenish the account with the required amount. This message is called a margin call.
How short trading works
Getting closer to margin trading vs short selling, let’s talk in more detail about how short trading works.
A short position is a method of trading on the stock exchange when an investor borrows from a broker shares that he does not own in order to sell them at the current market price in order to buy the same shares at a lower price and reap the benefits. In this case, the investor is limited by the terms of settlements, and opening a short position is associated with a high risk.
Imagine a situation: Microsoft shares are trading at $200, but we believe that the price is too high and the paper is about to fall, but we do not have these shares in our portfolio.
Then we borrow shares from the broker against the security of funds, and he sells them on the market. Next, we wait for the stock to fall, for example, to $180, and buy. When buying a stock, it will automatically return to the broker (remember that we borrowed them), and the difference between the sale and purchase will be our profit, in this case, $20.
All calculations regarding the minimum and initial margin, as well as the liquid portfolio, are similar to long trading, but the value of “short” is taken in the risk rate.
For each day of using the broker’s assets, we pay a certain amount, you need to familiarize yourself with the conditions of margin trading with the broker. However, this also applies to long trading, so it is better to use margin trading for short-term transactions.
Returning to the question of margin trading vs short selling it can be noted that trading short is much riskier than trading long. In the case of a short game, the mathematical expectation plays against us: the stock can fall to 0 as much as possible, minus 100%. And they can grow indefinitely, 100%, 200%, and even 500%.
When trading short, the investor puts himself in a deliberately dangerous position, so it is even more important to assess your risks in advance, determine the maximum possible losses on the transaction, and set a stop loss.
The main difference between a short and a long
In discussing margin trading vs short selling it is important to note the main differences between these two trading strategies are as follows:
- In a short position, investment instruments are used that do not actually belong to the trader: he borrows them from the broker. Such trading, when the client uses the broker’s assets, is called margin trading, or trading with leverage. An investor can trade long both at the expense of the broker’s assets and operating only with his own money.
- In a short position, a trader most often spends much less time than when trading long. This is due to the peculiarities of the market: assets always fall in price faster than they grow. Due to this, bears make comparable profits faster than bulls.
So we answered the question about the difference between margin trading vs short selling. But remember that both margin trading and short selling involve risks. Therefore, only professional traders can take such risks. But if you want to do it yourself, do your research and practice on your broker’s demo account before you start using these methods.