Trading FOREX Currencies on Margin
Without margin, the FOREX would be beyond the reach of the
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|The key to FOREX popularity is margin.
Without margin, trading FOREX would be beyond the reach of the average
investor. So, what exactly is margin and how does it work?
Margin accounts allow FOREX traders to control large amounts of
currency with a relatively small deposit. Establishing a
margin account with a FOREX
broker enables you to 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 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 is that with a 1% margin account you can
control standard lots of $100,000 with a $1,000 deposit.
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 usually brokers will terminate a transaction that extends
beyond the margin deposit.
Benefits of Trading FOREX on Margin
As we 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, and when you have a $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
So the benefit of margin is increased profit potential.
Risks of Trading FOREX on Margin
Any investment has risks,
and FOREX is not exempt. As there is increased profit
potential with trading foreign currencies on margin, there is also
increased loss potential.
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 methods to limit loss.
Stop loss orders automatically close your position if the value of the
currency crosses a pre-determined point. Stop loss orders
allow you to limit your losses to a specified amount while still
allowing potential profit taking.
An often overlooked risk is the possibility that your broker may close
your position if your potential losses approach the balance of your
margin account. You may be riding out a down trend with the
expectations of a market reversal, but unless you take actiona
andreplenish your margin account you may find your position has been
closed. If this happens, you lose all of your margin.
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.
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).
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