13 October 2011
The 3 Secrets of Margin Trading
By Teeka Tiwari - Creator: ETF Master Trader
A question I get asked often is, "should I use margin?"
For those of you that are new investors, margin is a tool used to leverage or "gear up" the buying power in your brokerage account. The way it works is that for every dollar in value you have in your account, your brokerage firm will lend you an additional dollar. So $10,000 in cash will buy you $20,000 worth of stocks.
Margin can be a very powerful wealth accumulation tool when you are right on your stock market calls, but it can be a wealth killer when you are wrong!
Like most things in life, if you’re an adult about it, there are ways to use margin very successfully without blowing off your fingers.
There are three keys to successful margin use...
Position Sizing
This is where a lot of people get in trouble. They hold positions that are way out of whack with the size of their account.
Here is the key with position sizing: Risk no more than 1% to 2% of your account value per trade. In my training program, ETF Master Trader, we call each of these 1%-2% investments a "unit of risk."
So does that mean if you have a $10,000 account, and use margin to bring that up to $20,000, that you only put $400 (2% of $20,00) into each trade????
NO!
Use a Stop Loss
This brings me to the second key to successful margin use.
When I talk about only risking 1%-2% of your account value, I am referring to the difference between where you buy a stock, and where you place your stop loss.
Here is an example...
A stock is trading at $20, and you have determined that your stop loss level is at $18.
So the risk per share is $2, and you have a $10,000 account. 2% of $10,000 equals $200. That means that if you are risking 2% of your account value, then you can buy 100 shares. This way if you get stopped out you only lose 2% of your account value (100 shares x $2 loss = $200).
Notice that I did not use your margin value of $20,000 to calculate the 2%. Instead I used the more conservative approach of your actual cash value of $10,000.
The advantage of margin isn't so that you can take bigger positions, because your position size will always be dictated by the amount that you are willing to lose (1%-2% of your account value).
The advantage of margin is that it will allow you to put on more positions.
Track Total Exposure
This is the most important part of margin trading, and something that very few investors are even aware of. Even if you use a stop loss and proper position sizing you can still lose money if you have too much market exposure at one time.
Let me explain...
If you have 15 open positions, all risking 2% of your account value, and the market gets slammed you could be looking at 30% in account losses. That is way too much risk to have on at any one time.
What I suggest to my ETF Master Trader subscribers is that they have no more than 6 units of open risk at any one time. Remember, a unit of risk is an open trade where we have risked 1%-2% of our account value. So if 6 trades go against you, you're looking at 6%-12% in losses, which is far more manageable.
Now this is the fun part -- if I've done my homework right and my stocks are going up, well then I will also be raising my stop as the stock goes higher. Remember: Our first stop is put on to save our money, and the second stop is put on to save our profit!
Here is the secret to making big money using margin...
As soon as my profit protecting stop either rises to or above my entry price, then lo and behold I have freed up another unit of risk to use in my trading. And that is where having access to margin can really allow me to cook when things are going my way.
This is because I am only adding more positions to my account as I move deeper and deeper into profits. But all the while, I am never risking more than 6%-12% of my original investment.
This is so powerful, because it keeps me from adding more units of risk when I am losing money, and has me adding many more positions when I am making money.
So, if I own a stock at $20, with an $18 stop and the stock goes to $25 and I adjust my profit protecting stop to $23, guess what? That unit is now in profits, and I have freed up another unit that I can add to my portfolio.
Remember: The most important thing to do is to always track your open units of risk. An open unit of risk is a position that you hold where its stop loss price has failed to reach or exceed your entry price. Never let your open units of risk rise above 6, never go bigger than 1%-2% of your account value per unit, and you will be well on your way to mastering margin and reaching your financial goals far faster and with far less risk than you ever imagined.
A question I get asked often is, "should I use margin?"
For those of you that are new investors, margin is a tool used to leverage or "gear up" the buying power in your brokerage account. The way it works is that for every dollar in value you have in your account, your brokerage firm will lend you an additional dollar. So $10,000 in cash will buy you $20,000 worth of stocks.
Margin can be a very powerful wealth accumulation tool when you are right on your stock market calls, but it can be a wealth killer when you are wrong!
Like most things in life, if you’re an adult about it, there are ways to use margin very successfully without blowing off your fingers.
There are three keys to successful margin use...
Position Sizing
This is where a lot of people get in trouble. They hold positions that are way out of whack with the size of their account.
Here is the key with position sizing: Risk no more than 1% to 2% of your account value per trade. In my training program, ETF Master Trader, we call each of these 1%-2% investments a "unit of risk."
So does that mean if you have a $10,000 account, and use margin to bring that up to $20,000, that you only put $400 (2% of $20,00) into each trade????
NO!
Use a Stop Loss
This brings me to the second key to successful margin use.
When I talk about only risking 1%-2% of your account value, I am referring to the difference between where you buy a stock, and where you place your stop loss.
Here is an example...
A stock is trading at $20, and you have determined that your stop loss level is at $18.
So the risk per share is $2, and you have a $10,000 account. 2% of $10,000 equals $200. That means that if you are risking 2% of your account value, then you can buy 100 shares. This way if you get stopped out you only lose 2% of your account value (100 shares x $2 loss = $200).
Notice that I did not use your margin value of $20,000 to calculate the 2%. Instead I used the more conservative approach of your actual cash value of $10,000.
The advantage of margin isn't so that you can take bigger positions, because your position size will always be dictated by the amount that you are willing to lose (1%-2% of your account value).
The advantage of margin is that it will allow you to put on more positions.
Track Total Exposure
This is the most important part of margin trading, and something that very few investors are even aware of. Even if you use a stop loss and proper position sizing you can still lose money if you have too much market exposure at one time.
Let me explain...
If you have 15 open positions, all risking 2% of your account value, and the market gets slammed you could be looking at 30% in account losses. That is way too much risk to have on at any one time.
What I suggest to my ETF Master Trader subscribers is that they have no more than 6 units of open risk at any one time. Remember, a unit of risk is an open trade where we have risked 1%-2% of our account value. So if 6 trades go against you, you're looking at 6%-12% in losses, which is far more manageable.
Now this is the fun part -- if I've done my homework right and my stocks are going up, well then I will also be raising my stop as the stock goes higher. Remember: Our first stop is put on to save our money, and the second stop is put on to save our profit!
Here is the secret to making big money using margin...
As soon as my profit protecting stop either rises to or above my entry price, then lo and behold I have freed up another unit of risk to use in my trading. And that is where having access to margin can really allow me to cook when things are going my way.
This is because I am only adding more positions to my account as I move deeper and deeper into profits. But all the while, I am never risking more than 6%-12% of my original investment.
This is so powerful, because it keeps me from adding more units of risk when I am losing money, and has me adding many more positions when I am making money.
So, if I own a stock at $20, with an $18 stop and the stock goes to $25 and I adjust my profit protecting stop to $23, guess what? That unit is now in profits, and I have freed up another unit that I can add to my portfolio.
Remember: The most important thing to do is to always track your open units of risk. An open unit of risk is a position that you hold where its stop loss price has failed to reach or exceed your entry price. Never let your open units of risk rise above 6, never go bigger than 1%-2% of your account value per unit, and you will be well on your way to mastering margin and reaching your financial goals far faster and with far less risk than you ever imagined.
Labels: CFD, Margin, Position Sizing, Risk Management, Stock Trading System, Thoughts
