Margin accounts permit forex traders to control lots of currency with small deposits. Establishing a margin account with a forex broker enables you to borrow money from the broker and be in charge of currency lots generally valued at $100,000.
In forex, this means that with only a $1,000 deposit, you can control standard lots of $100,000 from a 1% margin account.
With this level of borrowing power, a margin account gives you leverage. This leverage is typically expressed as a ratio. A leverage of 100:1 means you can control funds assessed 100 times more than your deposit.
The Benefits of Margin in Forex Trading
Trading on margin enhances your buying power and your potential profits. The benefit of margin is increased profit potential. So, you ask, how does this work?
Forex currencies are traded in units much smaller than cash. For example, the American dollar is traded in units taken out to 4 decimal places — $1.32 is seen as $1.3246. With a 1% margin account that let’s you control $100,000 for only $1,000, small changes in currency prices can create either very large profits or similarly, losses.
The pip is the smallest unit in forex currencies. When trading with $100,000 in American dollars, each pip is worth $10 in your total lot.
If the American dollar’s value varies from 1.3256 to 1.3356, that difference is 100 pips, which equates to either a profit or loss of $1,000. Without margin, $1000 of the same currency would result in only a $10 difference. Not a significant distinction to an investor.
The Risks of Using Margin
Forex trading has numerous methods to contain investor losses. For instance, stop-loss orders by design close your position when the currency values move beyond a prearranged point. Stop-loss orders limit your losses to a designated amount, while still permitting the potential of taking substantial profits.
A frequently ignored risk is the potential for your broker to close your position as your impending loss moves toward the balance of your margin account. You may be riding out a downtrend hoping for a market reversal. Unless you restock your margin account, you may discover your position has been closed. When this happens, you lose your entire margin.
You decide to purchase USD/CHF at 1.2623 with the hope that US dollars will gain against Swiss francs. 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 anticipated, the US dollar rises to 1.2683. At this point you close your position. You sell 100,000 American dollars for 126,830 Swiss francs. Your profit is 600 francs, or $473.08 in US dollars (600 francs divided by the exchange rate of 1.2683).
You sell EUR/USD at 1.2144 (sell 100,000 euros and buy 121,440 US dollars) predicting the euro value will decline. Your 1% margin account means that the required margin is $1,214.40. The $1250 in your margin account then leaves you with a $35.60 balance.
Assuming you haven’t communicated a stop-loss order and the euro suddenly rallies, gaining 0.0263 for a price of 1.2407, the 100,000 euros are now worth $124,070 in US currency. Your 1% margin requirements are now $1,240.70. Depending on your broker’s policy, the excess funds in your margin account may be used to make up the difference or your position may be automatically closed.
Either way, if you wish to ride it out and the euro continues to increase its worth, you must add funds to your margin account or risk losing it all.
With the possibility of improved profits, comes the potential of higher losses. It’s easy for your entire margin account to be quickly eliminated. The currency only needs to move 1 cent against a 1% margin account and $1000 is lost.
Trading on margin has the potential to greatly heighten either your profits or your losses. It’s important to remember that the potential does exist for a loss greater than your original deposit. With appropriate protections, though, losses can be constrained. With good communications with a good broker, your transactions will usually be terminated before you surpass your margin deposit.
The key to forex popularity is margin. Without it, the forex would be beyond the reach of the average investor.