Foreign exchange margin trading at first glance looks like a way of getting something for nothing.
Get it correct and you only have to risk a little of your capital.
It is actually a way of making use of leverage to multiply the buying power of your money. You use a little sum to control a much bigger amount.
The risk is controllable because it is improbable that the value of a currency, specially the major traded currencies, will move by more than a relatively small portion over the time that you make the industry. So if your brokerage account keeps a few hundred dollars you can industry on the margin – which is the total amount by which you believe the price will drop. Your kind-hearted broker in effect gives you the balance.
You will also encounter investing on margins in stock plus futures trading, but you get much more leverage in the foreign exchange market because of the unique nature of currencies. You could achieve a leverage factor of anything through 50 to 200 times the dimensions of your account balance, depending of course around the terms you have negotiated with your broker.
This can mean big profits in case you get it right, but the whiplash arrives comes in if you get it wrong, and you can experience equally big losses if not. As in life in general, there is no such matter as a free lunch. The more leverage you decide to use or are allowed to use, the riskier your investing.
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Have a look at an example.
You decide to trade the particular British Pound/US dollar pair. The current rate is shown as GBP/USD 1 . 7100. That means you need you should need $1. 71 to buy a single British pound. You decide that the buck is going to rise against the pound, so you sell enough pounds to buy $100, 000.
Assuming your broker uses lots of $10, 000 each, you will take a position on 10 lots. Then you sit back, relax (well, maybe not relax) and wait for the price to rise.
This time you get it right and within two days the price had relocated to GBP/USD 1 . 6600. The money has gone up and the pound is now worth only $1. 66. Sell your dollars, buy back into pounds, you happen to be 2 . 9% richer (less the spread). As 2 . 9% associated with $100, 000 is $2, nine hundred, you’ve made a very good trade.
But if you aren’t a banker with a nice end-of-year bonus, you probably don’t have $100, 1000 spare cash that you can use on the currency exchange market. And this is where the principle of forex margins kicks in.
Because you are buying and selling different foreign currencies at the same time, you only have to worry about any reduction that you might make if the dollar drops instead of going up. And of course you would restrict that loss by putting a stop loss in place. In this example, you will need only $1, 000 in your account to make this $100, 000 purchase. Your broker will guarantee the balance of $99, 000.
In the real world many brokers operate limited danger accounts, which means that the account automatically closes out the trade when the funds in your account are lost. This protects the trader since it prevents margin calls i. electronic., stops you losing you more than you have. A broker with many such balances could be driven out of business simply by adverse margin calls – this is why a limited risk forex account stops that from ever happening. The program provided by your broker, which you value to control your account, will simply not let you lose more than you have in your accounts.
Using leverage is an absolutely standard practice in currency trading, so standard that you will soon do it without also thinking about it.
But remember the whiplash likelihood and think about the risks involved. Within the face of it, lower leverage indicates lower profits – but a minimum of you get to survive the evitable ups and downs of currency trade. Unless you have got very deep pockets, it is a lot more sensible never to go to the maximum forex trading margin that your broker would allow.