Know the risks in margin trading

Know the risks in margin trading

Margin trading has become an increasingly popular way to trade stocks and shares among others.

It allows an individual investor to trade a large amount of stock with a much smaller capital base. This is because the investor is essentially borrowing money to trade the security.

In plain vanilla stock investing, an investor with $1,000 can buy only 1,000 shares of $1 each.

But with leverage of, say, 10 times via margin trading, the investor can now buy 10,000 shares of $1 each.

This allows small investors to take large positions that they otherwise would not have been able to afford.

The other attraction of such products, including contracts- for-difference (CFD), futures and warrants, is that investors can "short" the market, allowing them to profit even when the market falls.

But such products also mean that risk is magnified. If the investor's 10,000 shares of $1 each drops by 1 per cent to 99 cents, his paper loss is actually 10 per cent.

Some financial analysts disavow such products, saying that they tend to lead to investors biting off more than they can chew.

And for new investors with little or no trading experience, such leveraged trading products are certainly not recommended.

But for more seasoned investors who want to take a punt at trading such products, here are five things that they should pay attention to.

Manage your risks

The Oracle of Omaha, Mr Warren Buffett, once said: "Watch the downside and the upside will take care of itself."

Nowhere is this piece of wisdom more applicable than in leveraged trading.

Make full use of stops and limits to prevent your position from running too deep into the red.

But if your position is running well into the black, don't be afraid to let it run, especially if the trend is clearly on your side.

On the other hand, don't be afraid to cut your losses early. It's better to lose a battle and focus on winning the war.

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