- There has been a significant rise in trading on margin
- Although it can boost returns it also amplifies losses
Buying stocks ‘on margin’ or ‘with leverage’ sounds like a quick way to win or lose money, depending on your perspective. Unfortunately, in most cases it turns out to be the latter. Companies that allow people to trade contracts for difference (CFDs) have to disclose what proportion of their customers lose money on their websites, and this typically ranges from 65 to 80 per cent. Despite this, brokers which facilitate margin trading have seen a significant growth in customer numbers recently. IG, for example, which had a 36 per cent increase in the number of active leveraged clients in 2020 compared with the previous year.
For most people, trading on margin is not appropriate. But you might be curious to learn how it works and, for investors with the right risk appetite, a strategy that is carefully managed can help to boost portfolio returns.
When you trade on margin, you are essentially borrowing money from your broker to buy a security, meaning that you do not have to commit the full value upfront. If the underlying investment rises in value you can multiply your profits. But if it falls, your losses can rack up quickly. No matter by how much a position falls, you still have to pay back the money owed to your broker – plus interest. You can use risk management tools such as stops to cap any losses by closing out of a position at a certain level. For example, you could take a long leveraged position where you kept your upside open but imposed a stop to close out if your position fell by 10 per cent.
The main ways in which you can trade on margin in the UK are spread betting and CFDs. These are types of derivatives so when you buy them you don’t own the underlying security. Instead, you enter into a contract with a broker to receive returns based on the value of the underlying assets. Spread betting and CFDs also enable you to take a short position on an asset if you want to bet that its price will fall.
CFD trading and spread betting are similar, but the key difference is how they are taxed. Spread bets are only available in the UK and are free from capital gains tax (CGT). IG says that most of its customers who trade on margin do so via spread betting for this reason.
However, because CFDs are subject to CGT, losses on them can be offset against profits which might make them more tax efficient in some circumstances (if you make losses). You don't pay stamp duty on either product because you don’t take ownership of the underlying assets when you trade.
Unlike CFDs, spread bets have an expiry date at which point the profit or loss will be realised. This can be overnight, or over a number of months. This doesn't mean that you have to leave the spread bet open until the expiry date, as you can close the position at any time before then or roll it on if you want to keep it open. Daily funded bets are rolled over nightly.
How does leverage work?
The amount of leverage your trading provider will offer you depends on a number of things including how risky an asset is, how big the size of your position is and whether you are a retail or professional trader. The Financial Conduct Authority (FCA) has imposed rules on the amount of leverage that can be offered on different asset classes which applies to all retail traders.
Different brokers might offer different amounts of leverage, but will be in line with FCA rules. IG, the only London-listed broker to allow both underlying stock investing and derivatives trading, offers tiered margining. This means that the smaller the position you take, the lower the initial margin required.
If you take a position based on the price movement of an index, the minimum margin requirement tends to be lower than with individual shares because indices are perceived as inherently less risky. For example, a "tier 1” margin requirement with IG for a position on the FTSE 100 or S&P 500 index is 5 per cent. This means that you only have to pay 5 per cent of the cost upfront – a leverage equivalent of 1:20.
For popular shares traded on IG, such as Apple (US:AAPL), Barclays (BARC) and GlaxoSmithKline (GSK), the margin requirement is 20 per cent, so a leverage equivalent of 1:5. You can reduce your margin requirement, however, by using stops. Adding a stop limits your potential losses. Matt Brief, chief product officer at IG, says that about 30 per cent of leveraged positions on IG are opened with a stop loss attached to them, to limit losses if an asset’s price falls. Traders can also use a guaranteed stop loss, which means a position will be closed if the price hits a certain level.
IG’s most popular type of derivatives product is equity indices, which account for roughly 40 per cent of trading volume. Because these products are available over the counter as opposed to being listed on an exchange, they are tradeable 24 hours a day, five days a week, which Brief says offers flexibility that customers like and the ability to act in response to market moving events instantly.
Equities are the second most popular product, accounting for roughly 30 per cent of deals, with commodities, foreign exchange and options making up about 10 per cent each. Interestingly, Brief says that customers who take positions on individual shares are “almost exclusively buyers” and rarely take short positions on individual companies. But where customers take positions on equity indices, the split tends to be about 50:50 on long and short positions.
Costs
When you buy shares you typically pay a dealing fee, but when you place a spread bet, you pay the spread charged by the broker. This is the difference between the buying and selling prices, and most brokers charge their own spread on top of the underlying market spread. When you trade a CFD, you pay commission charges to the broker.
You also have to pay a funding charge if you hold a position overnight, which is effectively the interest rate for being able to take the leveraged position. At IG, this charge is annualised at 2.5 per cent.
