Margin is basically an act of extending credit for the purposes of trading. So, margin trading allows you to buy more stocks than you would be able to buy normally. Trading on margin is basically for traders with a reasonable amount of experience and a strict risk management policy.
Margin Trading: How Trading on Margin in the Forex Market Works
Just as banks lend customers money against a home equity, forex brokers also lend money to investors against the value of the assets in their portfolio. So, say you are trading on a 40 to 1 margin, for every $1 present in your account; you may be able to trade up to $40. Investors typically trade on margin when they are looking to invest in equities. Traders use the leverage of the money they have borrowed to buy more assets than they would be able to if they were to invest using their own capital. However, forex traders can also make the most of margin accounts.
How do you get started?
Sign up with an online or regular broker to set up a forex margin account. Such an account resembles a margin account used in trading equities. In both instances, the investor is obtaining a small loan from their broker. This loan is usually the same amount of leverage the trader is looking to take up.
Prior to trading, you would need to make a deposit in the margin account. You and your broker will agree on the amount of deposit required. For example, if you were looking to trade $50,000, then a 1% margin would be applicable, requiring that you make an initial deposit of $5,000 while the broker will cover the remaining amount. Higher trade limits may attract a higher margin of up to 2% instead of just 1%. Although traders are not required to pay interest on the margin loan, they may in fact attract an interest charge if the trade does not close prior to the set expiry date.
Going with the example above, the $5,000 would serve as collateral. If your trades result in your losing close to or more than $5,000, then your broker may ask you to make more deposits or to close the trade to mitigate yours and the broker’s risk exposure.
What are the pros and cons of trading on margin?
A major advantage of trading on margin is that it allows you to incur more gains than the money that is already in your account balance. For example, say you have $2,000 in your trading account; assume that each pip is valued at 20 cents and you incur $200 pips upon your first trade. The resultant profit would be $20 if you were not trading on margin. If you were trading on a 50 to 1 margin for example, the value of your trade would be $50,000 so that your 200 pips would give you a profit of $1000.
The disadvantage of trading on margin is the prominent risk exposure. An example could help to illustrate this: Using the example above, say your account has a balance of $2,000 and you start a trade with that amount. If you lose 200 pips, your loss would only be $20 if you were not trading on margin. However, if you were trading on a 50 to 1 margin, and made a loss of 200 pips, you would have lost $1000, wiping out half of your account balance.
As is evident, the profit potential and risk exposure for margin trading are equally great. A risk management strategy can help to alleviate your risk exposure.