Margin and leveraged trading

Now that you understand the basic nature of how forex trading works it's time to learn the concept of leverage and margin trading. As most of you will find, forex market is accessible with small amounts of capital because forex brokers provide high leverage options. Leverage increases the potential to higher returns with smaller capital. However it's a double edged sword. It can as easily create losses as it can generate profits.

Forex brokers take collateral in return for the high leverage options they provide. This is known as Margin. Currency pairs are usually traded in 100,000 unit standard lots or 10,000 unit mini lots. It simply means that a trader will buy 100,000 units of the base currency by selling the required amount of counter currency based on the standard exchange rate values. For example, when the ask price for EUR/USD is 1.2500, 100,000 Euros are bought while 125,000 Dollars are sold. For a standard contract (1 Lot) in which the USD is the counter currency 1 pip will equal $10 ($1 for a mini lot). For all other pairs exact pip values are slightly different and range from $8 to $10.


Leverage

100,000 in any currency is pretty much out of reach for most retail traders and definitely beginners. In the past, this was the case and for precisely this reason the forex market was not accessible to the larger public. Not anymore. Enter leverage trading!

While in the stock market you can leverage 2:1 (that is you can borrow $500 for every $500 you put in) in forex it starts from 10:1 and goes as high as 500:1. Don't get too excited and jump onto a high leverage trade. We will explain in later chapters how it can bite you back. However, it is thanks to leverage that most retail brokers can operate in forex. The trick is to balance risk and work with the right amount of leverage. High-leverage trading is the essence of what distinguishes retail forex from other markets.

How is this possible? In the forex market, when trading the established currencies, the amount that a currency changes in any given day is quite small. A one cent (or approximately 100 pip) change in the value of a currency is considered a large move. Therefore, forex dealers can afford to hold a fairly small amount of collateral for any given position.


Margin Call

If the market moves against a trader resulting in losses such that the trader lacks a sufficient amount of margin, there is an automatic margin call. The forex dealer closes the trader's positions and limits the losses for the client because this stops the account from turning into a negative balance.


Example

Let us assume you have a total balance of $2,000 in your account. You go ahead and buy 1 Lot of USD/JPY at a price of 97.50 (1 US Dollar buys 97.50 Yen) with the 100:1 maximum leverage. This translates to a margin of $1000 that the forex broker will take as collateral. If you close the position immediately, the $1000 collateral will come back into your account taking your total account balance or equity back to $2,000 minus the cost of transaction (usually a few pips).

But you decide not to close the position. When the position moves in your favour the gains are added to unrealized gains or floating equity. Similarly, movements against you will be subtracted from the floating equity.

If the price moves 100 pips in your favour (the exchange rate moves upwards one Yen to 98.50), then you make a $1,000 gain ($10 per pip × 100 pips). You have effectively made a 50% return on his or her $2,000 account, or a 100% gain on the $1000 margin. On the other hand, should the marker go against you a 100 pips, your position would have been closed automatically due to a margin call when the floating equity reaches $0 from $1000. The margin call results when your floating equity value hits 0. You end up losing 50% of your total equity in just one trade. This leads us to risk management.

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