CFDs 2: Margin Trading
Margin Trading
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Margin Requirements Buying shares on margin is similar to borrowing money through a margin loan to buy |
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Most people buy shares for cash; but if you use CFDs, you can place down a deposit,
known as a margin. This margin requirement is used to protect the CFD provider if
it has to sell a trader out of a position.
The margin requirement varies from share
to share (and provider to provider) between 3% (low risk, generally the top 100
shares) and 80% (more risky shares) of the face value of the share. This is the
margin rate. For indices or currencies, margin rates can be as low as 1% of the
value of the underlying security. Margin requirements are broken into two components
known as the initial margin and the variation margin. Margin requirements
are calculated each day.
Initial Margin
Initial Margin Calculation
The initial margin is calculated on the face value of the contracts held.
Let’s say you’d like to buy AUD$10,000 worth of the Australian stock, Commonwealth
Bank, (CBA):
If the margin rate is 5%, the initial margin requirement is $10,000 x 5% = $500.
This is the amount you have to put up to enter the position (not including commission
and limited risk premium).
For short positions, the calculation is exactly the same:
If you went short $10,000 worth of share value for CBA:
Initial margin requirement is $10,000 x 5% = $500.
See the CFD QuickCalculator for easy calculations of the IM.
Notes on Initial Margin
Some CFD providers will allow you to reduce your initial margin (IM) requirement
by setting stop orders or guaranteed stop orders closer to the share price than
the margin requirement. For example, if the stop is set 2% below the current share
price, then the IM requirement becomes 2%.
Check with your provider what your margin requirements are. Although a CFD provider
will charge a higher margin rate for a more risky share, it’s important to understand
that
it is not the IM that will have the most impact on your account, but rather
the variation margin. Variation margin is explained in the next section.
Limited Risk Premium
Many CFD providers will only allow new CFD traders access to a limited risk account.
The limited risk account allows you to place a guaranteed stop with your entries.
Typically the closest this stop can be placed to the share price is 5% (in order
for the trader to take some risk himself). This is a great loss-prevention measure!
However, for this privilege you have to pay what is known as a limited risk premium
(LRP), which is calculated as a percentage of the share value of the position.
The LRP rate varies from share to share, and is based upon the share’s risk-level
(similar to the margin rate). For example, the LRP rate of CBA might be 0.3%, in
which case a position of $15,000 share value worth, will have an associated LRP
cost of $45.
Variation Margin
Variation Margin Calculation
The variation margin (VM) is your daily profit or loss on a position. It is
directly proportional to the number of shares in the CFD contract.
Let’s go back to our CBA example again. If the share price of CBA is $50, and we
have entered a $10,000 share value position, on 5% margin, then we have:
Number of shares is $10,000 / $50 = 200 shares.
Our VM will thus increase by $200 for every $1 increase in the price of the share
(for a long position), and, similarly, decrease by $200 for every $1 drop in the
price of CBA. The opposite is true for a short position.
From the above calculation, it can clearly be seen that for cheaper shares, the
VM will be higher : thus resulting in higher leverage. Care must be taken since
very high leverages can be obtained. Consider a position where the share value is
$5000 (which at 5% margin only requires $250 up-front) and the stock price $0.20.
This will result in 25,000 shares being bought. Very small changes in the share
price will have a huge effect on your account: A positive move will be highly desired
since even a slight negative move could wipe out your entire account (and more)!
The variation margin is calculated daily by a process known as marking to market.
At the end of each trading day, any gain is credited and any loss deducted from
your account. This is called free equity (a unique feature of CFDs) and allows the
trader to enjoy improved cash flow in his/her account.
Try the CFD QuickCalculator for yourself a few times to get a feel for the effect of share price and share value on variation margin (number of shares).
Free Equity
Free equity is used to refer to the free cash in your account after margin requirements have been taken into account. If you deposit $10,000 into your account and you enter
$50,000 worth of CFD positions at 10% margin, then your initial margin requirement
is $5,000, leaving free equity in your account of $5,000. If the position moves
in your favour by $500 during the trading day, then your free equity will increase
to $5,500.
Conversely, if the position moves against you by the same amount, your free equity
will decrease to $4,500. If your free equity moves to zero, you will receive what
is known as a margin call. This is a request to deposit more money into your account
or decrease the position that you are trading.
Finance Charges
Interest Charges
When trading in CFDs, you are in effect borrowing money, as you are when you place down a deposit to buy a house. There is no interest charge on positions that are
closed the same day you bought them.
However, if positions are held overnight, that
is considered longer than one day, then interest is charged, or credited if you
are in a short position.
Interest is charged or credited on the face value of the transaction, which is the
total amount of the position (share value) NOT the initial margin. In the CBA example,
interest will be charged if you are long $10,000 or credited if you are short the
position.
CFDs are like a margin loan on steroids! The leverage is much greater with CFDs
than with a margin loan. The financing structure is also different to that used
in a margin loan. For a margin loan, an investor would contribute $30,000 and borrow
up to $70,000. Interest is only charged on the money that is borrowed. If a facility
of $70,000 has been approved and the investor is using $50,000 of the margin loan
facility, then interest is charged on the $50,000 that was borrowed. If a trader
has $30,000, then this can be used as initial margin, allowing the trader to borrow
up to $1m (at 3% margin).
If $500,000 of CFDs are purchased, then interest is charged on the whole
$500,000. There is no credit given for the initial $30,000 margin that is used,
although the trader will receive interest on the free equity in his or her account.
Interest rates vary from provider to provider and are usually based on the country’s
nationally accepted rates (e.g. in Australia, the Reserve Bank of Australia, or
in the UK, LIBOR rates). They usually add/subtract a margin for long/short positions
respectively. This interest rate margin usually around 3%. So if the RBA’s rates
are 5% p.a., your CFD provider might charge you 8% for long positions held and credit
you 2% for short positions held.
Some CFD providers link their interest rates to overseas base rates.
Check with your CFD provider how interest rates are calculated. Interest will be paid on the
free equity in your account at varying rates, depending on the provider. These are
worthwhile checking with your provider.