| | 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 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
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 investor.
So the benefit of margin is increased profit potential.
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, 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 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).
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