Trading FOREX on Margin
The key to FOREX popularity is the ability to trade on margin. Without margin, the FOREX would be beyond the reach of the average investor. So, what exactly is margin and how does it work?
The Magic of Margin
Margin accounts allow FOREX traders to control large amounts of currency with a proportionately small deposit. Establishing a margin account with a FOREX broker enables you to then borrow money from the broker to control currency lots which are usually worth \$100,000. The amount of borrowing power your margin account gives you is called the leverage. Leverage is usually expressed as a ratio – a leverage of 100:1 means you can control assets worth 100 times your deposit.
What this means in FOREX trading is that with a 1% margin account you can control standard lots of $100,000 with a $1,000 deposit. Let the buyer beware, however. Trading on margin increases both profits and losses, and the potential exists for the trader to lose more than his original deposit. With proper safeguards, however, loss can be limited, and good brokers will usually terminate a transaction that extends beyond the margin deposit.
Benefits of Trading on Margin
As mentioned above, trading on margin gives you more buying power and the potential for more profits (and losses). How does this work, exactly? A 1% margin account allows you to control a currency lot of $100,000 for $1,000. When dealing with $100,000 small changes in the price of the currency can result in large profits or losses.
FOREX currencies are traded in much smaller units than cash. The American dollar, for example, is traded in units down to 4 decimal places. Instead of \$1.32, FOREX quotes are seen as $1.3256. The smallest unit in FOREX currencies is called the pip (see glossary), and when you have $100,000 each pip of your total lot is worth $10 (when trading American dollars).
If the price of American dollars changes from 1.3256 to 1.3356, that's a difference of 100 pips which represents a profit or loss of $1000. Without margin, if you had $1000 of currency, the price change from 1.3256 to 1.3356 represents a difference of $10. Significant to the tourist, perhaps, but not the investor.
So the prime benefit of margin is increased profit potential.
Risks of Trading FOREX on Margin
As there is increased potential for profit, there is also increased potential for loss. If you are not careful, your entire margin account could quickly be wiped out. If your margin account is 1% and the currency moves just one cent against you, you lose $1000.
FOREX trading, however, has several ways you may limit loss. Stop loss orders automatically close your position if the value of the currency crosses a pre-determined point. Stop loss orders thus allow you to limit your losses to a specified amount while still allowing potential profit taking.
One often overlooked risk is the possibility that your broker may close your position as your potential losses approach the balance of your margin account. You may very well be riding out a down trend with the expectation of a market reversal, but unless you replenish your margin account you may find your position has been closed. If this happens, you lose all of your margin.
For example:
You sell EUR/USD at 1.2144 (sell 100,000 euros and buy 121,440 US dollars) with the expectation that the euro will fall in price. You have a 1% margin account which means the required margin is $1,214.40. You have $1250 in your margin account, so to enter this position your margin account is left with \$35.60.
You have not specified a stop loss order, and after you enter this position the euro suddenly rallies, gaining 0.0263 for a price of 1.2407. 100,000 euros are now worth US\$124,070 and your 1% margin requirements have risen to $1,240.70. Depending on the policy of your broker, your position may be automatically closed or the extra funds in your margin account may be used to make up the difference. In any case, if the euro continues to gain value and you wish to ride it out (bad idea) you will have to add more funds to your margin account or risk losing everything.
Another example:
You buy USD/CHF at 1.2623 with the expectation that the US dollar will gain against the Swiss franc. You buy a standard lot of 100,000 American dollars for 126,230 Swiss francs with a margin requirement of 1% or \$1,000.
As expected, the US dollar rises to 1.2683 at which point you close your position. You sell 100,000 American dollars for 126,830 Swiss francs for a profit of 600 francs or US$473.08 (600 francs divided by the exchange rate of 1.2683).
