However, there are ways to use the margin profitably and responsibly. There are a few simple rules to follow that will protect the money and provide access to more profits.
Five Margin Rules
1. Remember that margin is customizable
It can be used to the extent that the trader is comfortable and needs to use this resource. For a risk-averse trader, using perhaps five to ten percent of margin would be comfortable. For a more risk-tolerant trader, forty to fifty percent of margin could be more appropriate. The margin amount for each trade can be customized – using from zero to one hundred percent. Margin is not an all-or-nothing game. So, consider each trade individually and as part of your trading strategy and decide on how much margin is appropriate.
2. Never use your entire margin
No matter how risk tolerant you are, maximizing the available margin is unwise and limits one’s ability to take advantage of other trading opportunities. A wise rule would be to avoid using more than two-thirds (or approximately 60 percent) of one’s margin capacity. This provides room for volatility in one’s trading account without risking the dreaded margin call.
3. Examine the risk-reward ratio of each trade
Margin changes the amount of your potential profit and the amount of your risk (or potential losses) quite dramatically. A rule of thumb is that the risk-reward ratio should be a 1:2 ratio or even higher. Some traders use a minimum of 1:5, but this high ratio will limit your trading ability. Beginning traders may wish to use a 1:3 risk-reward ratio. Do the calculations. Decide if your potential reward is worth the potential risk. If not, look for another trade.
4. Be responsible with the extra funds made available by the margin
Remember that you are using credit. Trading on the margin is like entering a department store at Christmas after having just received a new credit card. Buying opportunities are everywhere, but discipline is essential. The credit card can quickly reach its spending limit. That’s when the perfect gift is found at the perfect price -- but you won’t have any more credit available. If your margin is at the limit, good trading opportunities cannot be taken to their maximum potential. Always exercise discipline.
5. Remember that margin trading is risky
A trader may want to use margin trading only when a trading opportunity is clear or the risk-reward ratio is very good. Many traders will avoid margin trading whenever the market looks over-extended, unsteady, or unclear in terms of its direction.