Margin Accounts Explained
The key to FOREX popularity is margin.
Without margin, the FOREX would be beyond the reach of the average investor. So,
what exactly is margin and how does it work?
Margin accounts allow FOREX traders to
control large amounts of currency with a relatively small deposit. Establishing
a margin account with a FOREX broker enables you to borrow money from the broker
to control currency lots which are usually worth $100,000.
The amount of borrowing power your
margin account gives you is the leverage. Leverage is usually expressed as a
ratio – a leverage of 100:1 means you can control assets worth 100 times your
deposit.
What this means in FOREX is that with
a 1% margin account you can control standard lots of $100,000 with a $1,000
deposit. Trading on margin increases both profits and losses, and the potential
exists for the trader to lose more than his original deposit.
With proper safeguards, however, loss
can be limited, and usually brokers will terminate a transaction that extends
beyond the margin deposit.
Benefits
As we mentioned above, trading on
margin gives you more buying power and the potential for more profits (and
losses). How does this work, exactly? A 1% margin account allows you to control
a currency lot of $100,000 for $1,000. When dealing with $100,000 small changes
in the price of the currency can result in large profits or losses.
FOREX currencies are traded in much
smaller units than cash. The American dollar, for example, is traded in units
down to 4 decimal places.
Instead of $1.32 FOREX quotes are seen
as $1.3256. The smallest unit in FOREX currencies is called the pip, and when
you have a $100,000 each pip of your total lot is worth $10 (when trading
American dollars). If the price of American dollars changes from 1.3256 to
1.3356, that's a difference of 100 pips which represents a profit or loss of
$1000. Without margin, if you had $1000 of currency, the price change from
1.3256 to 1.3356 represents a difference of $10. Significant to the tourist,
perhaps, but not the investor. So the benefit of margin is increased profit
potential.
Risks
As there is increased profit
potential, there is also increased loss potential. If you are not careful, your
entire margin account could quickly be wiped out. If your margin account is 1%
and the currency moves just one cent against you, you lose $1000.
For this reason I do not recommend a
margin accounts that give you more than 100 times your initial deposit (some
give up to 400 times) because of the unnecessarily high risk of large scale
loss.
FOREX trading, however, has several
methods to limit loss. Stop loss orders automatically close your position if the
value of the currency crosses a pre-determined point. Stop loss orders allow you
to limit your losses to a specified amount while still allowing potential profit
taking.
An often overlooked risk is the
possibility that your broker may close your position if your potential losses
approach the balance of your margin account. You may be riding out a down trend
with the expectations of a market reversal, but unless you replenish your margin
account you may find your position has been closed. If this happens, you lose
all of your margin.
For example:
You sell EUR/USD at 1.2144 (sell
100,000 Euros and buy 121,440 US dollars) with the expectation that the Euro
will fall in price. You have a 1% margin account which means the required margin
is $1,214.40. You have $1250 in your margin account, so to enter this position
your margin account is left with $35.60.
You have not specified a stop loss
order, and after you enter this position the Euro suddenly rallies, gaining
0.0263 for a price of 1.2407. 100,000 Euros are now worth US$124,070 and your 1%
margin requirements have risen to $1,240.70. Depending on the policy of your
broker, your position may be automatically closed or the extra funds in your
margin account may be used to make up the difference.
In any case, if the Euro continues to
gain value and you wish to ride it out (bad idea) you will have to add more
funds to your margin account or risk losing everything.
Another example:
You buy USD/CHF at 1.2623 with the
expectation that the US dollar will gain against the Swiss franc. 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 expected, the US dollar rises to
1.2683 at which point you close your position. You sell 100,000 American dollars
for 126,830 Swiss francs for a profit of 600 francs or US$473.08 (600 francs
divided by the exchange rate of 1.2683).
