For many people the key to Forex trading is the ability to trade
on the margin. Without this ability, many small investors would not be
able to trade the currency markets. But just what is trading on the
margin and how does it work?
A margin account allows a Forex
trader to open an account with a relatively small amount of money, and
to then control large amounts of currency. In effect, opening a margin
account with a Forex broker allows you to borrow money from the broker
to control large currency lots. The degree to which you can borrow is
known as leverage and is usually expressed as a ratio. For example, a
leverage of 100:1 means that you can control assets worth 100 times your
deposit.
By opening a 1% margin account and depositing just US
$1,000 you can control standard Forex and lots of US $100,000. The
ability to trade on the margin can clearly increase your profits, but it
can also increase your losses with the possibility that you could lose
more than your original deposit. Brokers, however, normally monitor
margin accounts closely and will terminate a transaction which extends
beyond the margin deposit.
While it is obvious that being able to
trade US $100,000 with as little as US $1,000 provides for the
possibility of both greater profit and greater loss, we need to look in a
little more detail at just how this works.
Forex currencies are
traded in much smaller lots than cash is. If we take the American dollar
for example, a Forex quote might read $1.3256, rather than the $1.32
which you might expect. This is because in Forex trading currencies are
traded in units down to four decimal places, with the smallest unit in
Forex currency being known as the pip. In a standard US $100,000 lot
therefore each pip is worth US $10.
If our example quote for the
American dollar of $1 .3256 were to change to $1.3356 this would
represent a change of 100 pips and a profit or loss of US $1000 and, if
you were holding US $1000 of currency, a profit or loss of just US $10.
This might be significant to a tourist but is unlikely to impress an
investor. However, by using your US $1,000 on a 1% margin account to
control US $100,000, your US $1,000 profit now looks far more healthy.
Of
course your risks are also increased and, if the American dollar moves
by just one cent against you on your 1% margin account, you stand to
lose your entire account.
Fortunately there are a number of tools
available to the Forex trader to help in minimizing any potential
losses. One such tool is the stop loss order which automatically closes
your position if the value of the currency reaches a level which you
set.
One price that Forex traders have to pay for operating a
margin account is that brokers normally have the right to override a
transaction when they believe that it may result in an unacceptable
loss. It may be the case therefore that, while you are riding out a
downturn in the market in the expectation of a market reversal, your
broker may close out your position and leave you with a substantial
loss.
Let's say for example that you sell EUR/USD at 1.2144 (in
other words sell EUR100,000 and a buy US $121,440) in the belief that
the euro will fall in price. Your 1% margin account has a balance of $1,
250 and so after the transaction costing $1, 214.40 the balance in your
account is $35.60.
After you have entered this position, and
assuming that you have not set a stop loss, let's say that the euro
gains 0.0263 for a price of 1.2407 making EUR100,000 worth US $124,070.
The requirement on your 1% margin account is now $1, 240.70 and,
depending on your broker's policy, the additional funds may be taken
from your account or, with such a low balance, your position may be
closed. In any event, if the euro continues to gain in value, you will
need to add further funds to your account or risk your account being
closed and losing everything.
Despite the risks of trading on a
margin account it is this ability which makes Forex trading such an
attractive proposition to so many people. You should not therefore be
put off by these risks, but you certainly need to be aware of them and
to know your broker's policy and to manage your account accordingly.
LearningForexTradingOnline.com is the ideal place to currency trading and provides information on a range of topics including such questions as how does day trading work.