Currency trading margin trading at first glance looks like a means of getting something for nothing.
Get it right and you only have to risk a little of your own capital.
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It is actually a way of making use of leverage to multiply the purchasing power of your money. You use a little sum to control a much bigger sum.
The risk is controllable because it is unlikely that the value of a currency, particularly the major traded currencies, will proceed by more than a relatively small portion over the time that you make the business. 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 fall. Your kind-hearted broker in effect gives you the balance.
You will also encounter investing on margins in stock and futures trading, but you get much more leverage in the foreign exchange market because of the exclusive 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 within the terms you have negotiated with your agent.
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 suffer equally big losses if not. Such as life in general, there is no such thing as a free lunch. The more influence you decide to use or are allowed to use, the riskier your trading.
Have a look at an example.
You decide to trade the British Pound/US dollar pair. The present rate is shown as GBP/USD 1 . 7100. That means you need you would need $1. 71 to buy 1 British pound. You decide that the dollar is going to rise against the pound, so you sell enough pounds to buy $100, 000.
Assuming your broker utilizes lots of $10, 000 each, you would take a position on 10 plenty. Then you sit back, relax (well, not relax) and wait for the price to increase.
This time you get it right plus within two days the price had moved to GBP/USD 1 . 6600. The dollar has gone up and the pound is currently worth only $1. 66. Sell your dollars, buy back into pounds, you are 2 . 9% richer (less the spread). As 2 . 9% associated with $100, 000 is $2, 900, you’ve made a very good trade.
But if you are not a banker with a nice end-of-year bonus, you probably don’t have $100, 500 spare cash that you can use on the currency exchange market. And this is where the basic 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 loss that you might make if the dollar falls instead of going up. And of course you would restrict that loss by putting an end loss in place. In this example, you might need only $1, 000 in your accounts to make this $100, 000 buy. 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 because it prevents margin calls i. electronic., stops you losing you a lot more than you have. A broker with many such balances could be driven out of business simply by adverse margin calls – which explains why a limited risk forex account prevents that from ever happening. The software program provided by your broker, which you value to control your account, will simply not let you lose more than you have in your account.
Using leverage is an absolutely regular practice in currency trading, so regular that you will soon do it without actually thinking about it.
But remember the whiplash probability and think about the risks involved. Within the face of it, lower leverage indicates lower profits – but at least you get to survive the evitable ups and downs of currency trade. Unless you possess very deep pockets, it is much more sensible never to go to the maximum fx margin that your broker would allow.