What is Margin
Margin and leverage are the two things that make currency trading so popular – and so accessible, but what are they?
Forex margin accounts allow FX traders to control a large amount of currency with only a small deposit. This allows everyone with a computer and an internet connection to get started with currency trading.
In FX, leverage is usually expressed as a ratio, while margin accounts are expressed as a percentage. For example, a margin account of 1% would give you 100:1 leverage. So with $100 you could control $10,000 of currency. If the $10,000 of currency that you buy increases in value, you get all of the profits – but if that currency decreases in value, you are liable for all of the cost. Many people are wowed by the profit potential, and don’t stop to think about what would happen if the trade went wrong.
Trading on margin increases your profit potential, but also increases your risk of losses. If the market crashes, then it could be possible for a trader to lose more money than the original deposit – and end up in debt to the FX broker! Fortunately, most online FX brokers will end a trade if it falls below the amount deposited, minimising your losses – but you’ll still have lost the money that you had deposited, you just won’t end up owing a lot more.
If you end up in a position where the currency pair you are trading loses so much value that you don’t have enough money in the account to cover that loss, and the broker steps in to ask you to deposit more money or securities or sell the currency, then this is known as a margin call (or a maintenance, or fed call in some parts of the world). This is really a worst case scenario, and not something that you want to have happen to you.
For this reason, care should be taken when trading on margin. Beginners should pick trades that are considered safe, and watch them carefully. Don’t cling to a trade that is dropping hoping that the trend will reverse if all common sense indicators say otherwise. The profit potential for ‘safe’ trades may not be mega-bucks, but most daytraders make their money by making several trades per day – getting in when prices are low, and selling once they’ve risen a little. Lots of small profits are better than one huge loss!
FX trades involve fairly minor differences – a pip can be a fraction of a cent – so you need to be trading fairly large amounts in order to see a profit of any real size. Margin accounts make it worthwhile for even those without large funds to trade. Proper use of trading tools such as the stop loss option can ensure that you minimise the risk of trading on margin, whilst still being open to the profit potential of this useful and powerful trading tool. If you’re a novice investor, try not to use the full amount of margin that is at your disposal. Even if you’re working with a generally reliable signal provider, it’s a good idea to minimise the risks that you take, at least until you have built up a big enough savings buffer to be able to cover yourself if the market did bottom out.
Before you trade make sure you understand how stop loss orders are handled at your chosen online Forex broker, and that you know what they will do if your trade does go bad. Terms and conditions vary from broker to broker, so understanding exactly how your broker works is vital.
Tips for Trading on Margin
Trading on Margin can be a tempting proposition, as the potential gains can be huge. Before you start trading on Margin, make sure that you understand all of the rules. Don’t rely on your broker to protect you. Make good use of the stop loss orders mentioned earlier to ensure that you don’t end up owing money to your broker if (or, more accurately, when) things go wrong. Even the best traders have bad days, and a facing a Margin Call is not a good thing.
It’s also a good idea to have some backup funding. When you start trading, don’t buy into a currency all in one go. Hold some funds in reserve and start your trading gradually, re-investing a portion of your profits as you go. Yes, this means you could potentially miss out on mega-bucks, but it also means that if you do make a bad trade your account will like to trade another day. Considering that the vast majority of novice traders run out of cash within the first year, and margin trading makes that event come even more quickly than normal for most people, caution should be the order of the day.
Margin trading can work well with a quality signal provider, however in the early days it’s best to use as little leverage as you can get away with in order to trade on that broker. Save the huge leverages for when you have a bigger safety net.
Want to learn more about Forex terms, why not check out our Forex glossary.