Trading Online Simplified - Part 1

Trading at its Simplest 

Trading language can sometimes be the biggest barrier to new traders and investors learning, and even here I’m sure that I’m guilty of accidentally overcomplicating things that are meant to be made simpler. Those starting to look at investing or trading should certainly check out www.investopedia.com for a simplification of most financial matters, and this post will form part 1 of a 3 part series aimed at simplifying trading and investing language for trading beginners.

Leverage

This word is often used on the financial news and when people discuss online trading or investing. It refers to borrowing money and adding that to your own investment pool, so that you can invest more. Naturally you pay interest on the amount that you borrow, but you can now invest your original amount, plus the amount loaned to you, meaning that your 10% profit now makes more money for you than before you added the loan to your investment pool. It’s great if you’re making money, but as banks all over the US in 2008 found, borrowing more money to invest means that you lose far more than you would if you were only investing your own money when things go pear shaped.

Leverage Ratio

The leverage ratio is sometimes abbreviated to LVR, and refers to the amount that the bank will loan you. It is written as a %, for example 70%, which means that for every $3 you have, the bank will lend you $7 (70% of the total amount). The riskier the thing that you are buying, the less the bank will lend you as there is more chance of you losing their money, but when trading larger stocks, metals or forex pairs you can get the bank to contribute 90% and above, turning your original investment amount into a far larger sum.

Margin Loans and CFDs

A margin loan refers to a loan that the bank gives you, for the purpose of investing or trading online. The bank lends you money in the form of a line of credit, meaning they lend you a set amount towards every investment you make, depending on what that investment is (higher quality investment means higher leverage ratio and higher amount the bank lends you for every $1 you put in). You pay interest on that amount, and when you exit the trade or investment, that money goes back to the bank, and you no longer pay interest on it until you need it again. Essentially, it increases your investment size, allowing you to make or lose more money.

Think of a CFD (contract for difference) as a piece of paper, and on that paper contains the details of whatever you want to buy and sell, whether it is foreign currencies, shares or gold. You aren’t actually buying or selling gold bars themselves, you just have a piece of paper on which the price you bought and sold at are recorded. The agreement (contract) is that you receive the profit that you make or pay the loss (this is the difference part). You never own the thing that you bought, you just pay the price difference between the price that the share/gold was trading at when you bought/sold it. Because no one needs to find that gold bar and put it in a safe for you, you can get higher leverage ratios on products with CFDs over them, meaning you can both make and lose more money than if you were using a margin loan, or no loan at all. The company offering the CFDs is usually a form of bank, so they also offer you a line of credit as with the margin loan, just they are prepared to loan you more.

Margin Calls

These are when you lose more money on your investment than you have in your trading account, and you need to pay the difference, quickly. This occurs when the bank contribute money through your line of credit (leveraging), so your $1 was increased to $5 thanks to the bank. If your $5 investment falls to $3, your account is at -$1 once you’ve paid the bank back what they lent you, so need to pay them an extra $1 to prevent your account being in credit (owing the bank).

In the pipeline: Trading Online Simplified – Part 2

Bullish on: Australian mining stocks (Chinese monetary policy easing will increase growth and demand for resources)

Bearish on: US 10 yr Treasury Notes (yields too low relative to S&P), USDJPY (Japanese fundamentals and save haven nature to drive pair lower)

As always, please leave any comments or questions that you have, and if you’re looking for more trading ideas try www.pimmtrading.blogspot.com.