What is Forex Margin Trading?

As we have already shown the major part of all transactions in the market are made by market-makers – that is Central Banks and large private banks. One deal alone between these two types of entities can amount to hundreds of millions or even billions of US dollars. Of course, most people can only dream of those amounts of money changing hands. More than 30 years ago, however, there was no hope for a private investor getting into trading Forex – because there was no interest from these large banks in trading with their capital.

In 1986, however, small private investors began entering the Forex market. And what happened after that? The opportunity for these investors to speculate using margin accounts arose which means they were able to borrow money from their broker or bank to increase their buying or selling power – like the increased lifting power from a lever, only in financial rather than physical terms. Later on, with the development of Internet technologies almost any person could trade usingcomputer terminals and anyone can now use the leverage provided by margin.

The concept of margin is very simple – it allows a trader to operate with sums higher than his real budget. A broker provides his client with something called “credit leverage” or “shoulder” and the customer pays a sum of money for that credit called margin. The correlation between the credit given and the margin of a customer is usually called leverage and is formulated as a fraction or percentage. Thus a leverage of 1:100 means that a trader is able to operate with a sum that is hundred times bigger than the sum in his account (the margin at the brokers). The fraction 1:100 can be formulated as 1% (an alternative method of displaying the margin). In this case, the meaning is: The size of the margin for the trader’s account must be not less than 1% from the sum he’s operating on market.

The more stable the market, the more chance a broker has of providing a bigger leverage to his customers (sometimes even 1:500) and the Forex market is very stable in comparison with the equities’ market. Daily rippling on Forex seldom exceeds the 2% level. That’s why Forex brokers provide more beneficial terms than traditional stock market brokers do.

Margin is practically a pledge for a trader to cover broker’s losses on credit in case the deal turns sour. Thus, leverage is a factor displaying the maximum correlation between the sum a trader can trade with and the real amount of money in his account. In fact, all this leverage terminology appeared because of the likeness of margin trading with work of a physical lever. It’s worth mentioning that big leverage increases not just the potential profit, but risks too.

The principal functioning of margin trading is as follows. A trader opens a margin account with a broker and deposits some money into it as margin. At the moment the trader makes an order through the broker, the brokerage company (it can also be a bank, depending on who provides the service) starts an operation from its own account automatically, lending money in the currency needed. The broker “freezes” part of the margin to supply the deal, and the other part left is used if a trader incurs losses. If the the subsquent trade makes a profit, the broker (or bank) adds the proper sum to the trader’s account and the frozen part of the margin unfreezes (in other words, a trade returns previously given credit).

The broker or bank can also close a client’s trade when the estimated loss on the trade reaches the amount of the sum of money left in the margin account. This operation is called a Margin Call or sometimes a Stop Out.

This is understandable given nobody will compensate your losses for you. The broker wants to be sure your trading account doesn’t go below zero.

Margin trading is not always suitable in volatile currency pairs. This is because if you had predicted the rise of a currency but before reaching the end target for the trade it fell in a sudden move back down – so deep that the loss for the trade exceeded the margin on your account – the broker would automatically make a Margin Call or perform a Margin Out operation. In this case you would bear losses in spite of making the right prediction. This situation suggests that you need to consider not only the expected profit but also the possible intermediate losses in a trade.

Margin trading example

Some reference dealer (broker or bank) lets the trader use 1:100 leverage. In other words, a trader must supply his account with a sum that is equal or bigger than 1% of the price of the security he wants to purchase.

Let us say a trader makes a deposit of 5000 US dollars to his account and opens a position for 100000 GBP/USD at the rate of 1.8046. At that very moment the dealer buys 100,000 GBP for him, providing a credit of 180460 US dollars and freezes 1% of the credit (1804.6 US dollars) in his account. The 3195.4 US dollars left in his account will be used as a mortgage for possible losses until the trade has finished.

Let us suppose the rates were advantageous, predictions came true and the exchange rate of GBP/USD experienced an advance to 1.8102. The trader decides to close the deal and sell 100000 GBP/USD at the rate of 1.8102. As a result he gets 181020 US dollars. The dealer receives his credit of 180460 US dollars back and the difference of 560 US dollars goes to the trader’s account. Those are his earnings. Naturally the frozen 1804.6 US dollars (or 1% from the given credit) unfreeze and the sum on the traders account becomes
5560 US dollars.

If the deal was disadvantageous and GBP/USD bought for 1.8102 was sold for 1.8046 – so the trader lost those 560 US dollars instead – then the amount of money on his account would be reduced to 4440 US dollars. Thus, we can distinguish advantages and disadvantages with margin trading or the trading with leverage, and these are as follows:

Advantages

• You can access the market with a tiny sum of money, $10 can be enough to make $5000 worth of deals.
• Even so, you won’t stand to lose more than you have in your account, because the broker can use a Margin Call or Margin Out to close the trade.
• 1:100 leveraged trading profit is always 100 times bigger than the profit you could get with your deposited money alone. Forex4you accounts have 1:500 leverage which means you can earn 500 times more!
• As giving and returning of a credit is an automated process (it falls to dealer’s lot, not the trader’s) one can have a deposit in any convenient currency.

Disadvantages

There is only one disadvantage – the rise in risks which are in direct proportion to the rise in income.