What is the Margin of Safety and How can I Calculate it?
The margin of safety is a trading strategy or tool for investors. It is designed to judge the right time to enter a particular market, with the least potential risk.
When trading CFDs online, the margin of safety dictates that you only buy, or open, a position on a market when its price is judged to be lower than its true value.
You may have heard the old adage of “buy low, sell high”; the margin of safety is broadly similar. If you follow its principle, you should open a position when the financial instrument you want to trade is undervalued. This way you can later sell at a higher price.
Understanding the exact point at which to enter the market will be dictated by your appetite for risk and how aggressive your overall trading plan is.
The purpose of trading within your margin of safety is to minimise potential downside risk and provide a small risk of loss before your position or investment becomes profitable.
Margin of safety explained
The simplest explanation of the margin of safety is that it broadly represents the lowest price point you feel an asset or financial instrument needs to meet before the market corrects to reflect its true value and as a trader, you will need to make a judgement call, in conjunction with trading research and analysis, to determine where that point is.
Once you feel a market has reached your pre-determined, researched level, you can open a buy position. Then you’ll have to wait for the price of that market to rise. Because you’re entering the market when the asset is undervalued, your position could become profitable more quickly. This could also mean there may be less potential for losses.
Calculating margin of safety
Calculating the margin of safety, and determining the best time to enter the market, will be influenced by a range of factors. They include volatility and your appetite for risk.
Understanding how to read market charts and analysis is critical to defining a suitable margin of safety. Developing a strong understanding of your chosen market, and its historical bullish and bearish sentiment, would be advantageous to any trader.
For example, imagine you’re trading shares in Company X. Company X makes laptops but has been performing poorly recently, so the share price has declined as a result. However, you know that the company has a new AI assistant launching soon in a new model line. It is also set to expand into China and Japan.
You feel Company X’s stocks are undervalued and within the margin of safety. You believe they may rise in value if their new model and expansion is successful.
Your research and market knowledge gives you the impression that the current Share price is undervalued. It is within your margin of safety. Therefore, Company X’s shares represent a relatively low-risk trading opportunity.
Remember, leveraged trading carries risks
Trading within the margin of safety can help offset some of your potential losses and ensure your position achieves timely success. However, no trading strategy is risk-free.
Remember, when you trade CFDs online, you’re trading on leverage which amplifies both potential profits and possible losses. The market can move both ways and excess volatility can quickly create new historic lows in any market. This could make your margin of safety calculations less helpful.
Leverage works by allowing you to take a larger market position than may otherwise be possible with a small initial investment.
For example, in March 2021, Tesla Shares were trading at a range of $563.00-$718.43. To invest directly, you’d need to pay the full price for every Share you wanted to purchase.
With leveraged trading however, you could open a position on the price of Tesla Shares in the underlying market with a much smaller investment, say $100. For every point the market moves in your favour you’d earn an equivalent of your investment.
Creating a trading plan
Trading in the margin of safety is one of many potential trading strategies that could help improve your success as a trader.
Learning more about how and when to enter the market, how to identify trading opportunities and the tools available to you to manage risk is key to becoming a more confident trader.
We cover all of this and more in our Trading Education Hub. There you can also learn more about trading on leverage, what margin is and how it affects your trading, and how to read trading charts. The stronger your trading knowledge, the better you will be able to trade your chosen markets.
Remember, staying on top of market-moving events, news and data releases is essential too, and you can stay up to date on financial news across a variety of assets thanks to our weekly newsletter.
Trading on margin is high risk.