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 The key to Forex popularity is margin. Without margin, the Forex would be beyond the reach of the average investor. So, what exactly is margin and how does it work?
Margin is basically an act of extending credit for the purposes of trading. When an investor uses a margin account, he is essentially borrowing to increase the possible return on investment. Most often, investors use margin accounts when they want to invest in equities by using the leverage of borrowed money to control a larger position than the amount they'd otherwise by able to control with their own invested capital. These margin accounts are operated by the investor's broker and are settled daily in cash. But margin accounts are not limited to equities - they are also used by currency traders in the Forex market.
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.
Forex currencies are traded in much smaller units than cash. The U.S. 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 currencies is called the pip, and when you have a $100,000 each pip of your total lot is worth $10 (when trading U.S. 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. So the benefit of margin is increased profit potential.
Margin trading is very powerful tool. Investors can use it to make impressive gains and simultaneously risk excessive loss. Trading on margin effectively is best done with a reasonable amount of experience and a strict risk management policy.
Risks
As there is increased profit potential, 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 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 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 money.
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