The popularity of forex trading is
partly due to margin accounts using leverage effect. Without this margin,
trading currencies on the forex would be out of reach for retail investors.
Margin accounts are available to trade on all sorts of markets, going both up
and down. You can therefore trade the market online through a CFD broker, currencies through a forex broker
as well as commodities, indexes, ETFs, precious metals, etc…
What is margin and leverage effect?
Margin accounts allow one to control large sums of money with a
relatively small deposit. Opening a margin account with a forex broker allows
you to borrow money from the broker to trade currency lots that typically have
a value of $100,000. The amount of money you can borrow from a margin account
is defined by the leverage effect. Leverage of 100:1 means that you can control
assets that are 100 times larger than your deposit.
With a 1% margin account (leverage of 100:1), you can trade a standard
lot of $100,000 with a deposit of $1,000. Trading with leverage increases both
the potential for profits as well as losses. The trader can therefore quickly
lose his initial deposit if he doesn't respect strict risk management rules.
Typically, brokers have a system in place which limits the maximum loss to the
amount of the initial deposit by automatically closing positions if the loss is
too high. This is called a margin call or a stop out.
The advantages of leverage in a forex trading strategy.
The advantage of margin accounts is that it allows you to profit from
small currency market movements. It is possible to make profits even if the
market is not very volatile. Forex currencies are quoted with small units,
sometimes up to 5 decimals. The reference unit is the pip, which represents a
variation of 0.0001, or the fourth number after the decimal. For example if you
trade with a lot of $100,000 on the EUR/USD pair, each pip is worth $10. However,
the value of a pip depends on the currency cross.
If the price of the EUR /USD goes from 1.4050 to 1.4150, there is a
difference of 100 pips which represents a profit or loss of $1,000. If you had
traded without margin with $1,000, a price move from 1.4050 to 1.4150 would
have yielded a profit or loss of just $10.
The risk of using leverage
Using leverage increases the potential for profits, as well as losses! If
you're not careful, your margin account can quickly evaporate. With a 1% margin
account, a 1% move in the wrong direction can make you lose $1,000.
Forex traders nevertheless have several tools at their disposal to limit
losses. They can notably use stop loss orders to automatically close their
positions if the value of the currency reaches a previously defined point. Stop
loss orders allow them to define a maximum tolerated loss in advance, this is a
key aspect of money management.
