The Peaks and Pitfalls of Margin Trading in the Forex Market
10/14/2014 9:00 am EST
Casey Stubbs of WinnersEdgeTrading.com outlines the fundamentals of margin trading in the forex market, including the difference between margin and leverage and how forex traders can protect their margins by always placing stop losses.
When you hear the word margin in the forex market, this is referring to the minimum amount of cash you can have in your account in order to make a trade. This number is typically set by your broker, who, if he is located in the United States, is being regulated by the government. Margin allows for you to enter a trade with more money than you actually have.
How much money you have—or margin—determines how much your broker will let you trade with leverage. This is important for forex traders as movements typically equate into very small gains unless you have a significant amount of money invested. Brokers will allow you to use your margin to access a larger amount of funds thereby giving you a greater opportunity to gain more money.
If, for example, the broker you have chosen allows for a 50-to-1 margin. With every one hundred dollars in your account, you can trade five thousand. This allows you to amplify your potential gains by 50 times. The downside, of course, is that you are also amplifying your potential losses.
One of the fundamentals about this concept that is confusing to new traders is the fact that they are not using any of their own money, or margin, in a leveraged trade. Your money is being held as collateral in your account to cover the loss if your trade does not pan out as planned.
The Difference Between Leverage and Margin
Both leverage and margin are in reference to the same general concept. Leverage is the degree at which you are opening your position. Margin is the amount of money you have set aside to cover that leverage. This will be a fraction of what you are actually borrowing.
Margin will be represented as a %, while leverage is a ratio. So if you are using 50-to-1 leverage on a $10,000 trade, your margin is 2% or two hundred dollars. That is the minimum amount you will be allowed to have in your account in order to enter that trade.
When you look at your margin versus how much you can actually risk in the forex market, it is easy to see why it is enticing to so many traders. Of course, the downside here is that you stand to lose more.
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If you were to make a $1,000 trade with no leverage and lose 100 pips, your personal loss is going to be $10. If you leverage that same trade with a 2% margin, you are now trading $50,000. Losing 100 pips means you lose $500, or half of your account balance. So while the gain would have been significant, the loss has taken a big chunk out of your money.
Your broker is not offering you this loan without protecting himself. The margin you have in your account is going to be used to pay him back if your trade heads off in the wrong direction. He is also carefully monitoring that and will put a stop to your trade once your loss equals your margin.
Looking at the above example, your broker would have made the margin call once the loss hit 200 pips. That would be the equivalent of the amount of money you were using as collateral for your leverage. This is a small scale version of what may happen; imagine if your margin is in the thousands of dollars and you were using it all to back your leverage.
How to Use Your Margin Wisely
It would seem that with the potential for loss, it would just be wiser to either, only invest your own money and very slowly watch your account grow pip by pip, or to leave the forex market altogether. You don’t have to do either one if you learn how to manage your margin. This starts with understanding the risk to reward ratio of every trade you are considering and leveraging it accordingly.
Another point to remember is, with a margin call, you have to take into consideration the fact that some currencies will fall before they begin to rise. If you don’t have enough margin in your account to hold your position, the broker is going to end your trade before the turnaround. You have to keep that in mind when planning out your trades if you intend to leverage them.
Using a stop loss order on every one of your open positions will help to protect your margin and prevent your balance from falling to the dreaded margin call limit. Once it reaches that point, you effectively could have all of your funds wiped out in one bad trade. If you place a stop loss at a point before that, you can manage to salvage at least a percentage of your account and live to trade another day.
For forex traders, your own money is essentially just a tool that allows you to borrow more. This is what makes the market so appealing to so many. Use that power wisely by instituting solid plans that take into account your risk to reward ratio. By considering the risks and placing your stop loss orders accordingly, you can take full advantage of your margin without causing its total demise.
By Casey Stubbs, Founder, WinnersEdgeTrading.com