Margin trading is good news for traders in the Forex market, especially if one is trading below what many consider as large transactions. Yes, you can go big or go home, but that doesn’t always apply to your average Forex trader, and that is where margin trading comes in.
What is a margin?
Considered collateral or a “good faith deposit”, margin is required to open and keep positions on currencies open. With this arrangement, a trader can simply open a margin account with a brokerage firm, fund the account, and begin trading.
The amount needed to fund a margin account varies, but it is usually a percentage of 1% or 2% of the brokerage firm trades. This way, you can come up with lesser capital in exchange for a bigger trade.
By definition, this is a form of leverage. In essence, you are using borrowed capital to take positions in the Forex market by trading in larger amounts, thereby increasing your potential returns. But trading in margin is a different story – buying and selling using a margin cannot provide leverage, whether in or of itself.
What does trading in margin mean?
To illustrate: suppose you opened a margin account for Forex trading by transferring $5,000 cash in that account. If 100:1 leverage is allowed under this agreement, you can expect $500,000 worth of currency as maximum trade amount. This is possible because only 1% of the total price constitutes your collateral.
The example given implies that with a $5,000 margin, you are increasing your power to buy or sell currencies. In reality, the amount of margin you can take out normally depends on the amount of money in your account. Hence, buying and selling under a margin arrangement does not guarantee leverage in itself.
With more power to buy and sell, you are, in effect, augmenting the potential returns on your investment, all with less cash-out. This comes with a tradeoff, though as margin trading can magnify your profits, it can also go the other way and increase your losses. And there is also that possibility that the dreaded margin call may come at any time.
What is a margin call?
No trader wishes to receive a margin call. But in rare instances that they do, a trader should be ready to shell out additional funds to maintain a required balance. Failure to comply and fund the needed capital may require the broker to close some or all of the open positions associated with the margin account to prevent a negative account balance.
The losses on these accounts are a result of an unfavourable price movement that consumed a portion of the available margin deposits. That is why it is necessary to understand the risks involved because margin trading does not always mean profit. It is also possible that a partial or total liquidation of your positions can happen should your margin account fall short of the predetermined threshold.
To effectively avoid margin calls, you need to monitor your account regularly. You have to be fully aware of how margin accounts and how your margin agreement with the broker works. In case of concerns, you can always clarify matters with your broker.
Setting stop-loss orders for every open position helps limit your risk. It must be noted that a massive slippage can happen to your stop-loss should the market move fast.
What are the pros and cons of margin trading?
While risks are present in every kind of trading strategy, margin trading has many benefits. The greatest advantage, as any trader would attest to, is the boost in purchasing power. You can diversify your portfolio or increase gains even with a relatively small amount to begin with, as long as you agreed with your broker on this strategy.
Another benefit is having more options when trading. With a cash account (instead of a margin account), you might be stuck on basic trading alternatives in a way that you’re limited with how much your fund is able to buy. With margin trading, you can opt to short-sell or maintain a diversified portfolio.
The biggest risk in margin trading is the uncertainty that comes with a volatile Forex market. Your margin deposit absorbs the trade losses, and that is why a margin call may come your way when the balance falls below the required amount. You can never be too sure all the time, that is why your broker will help you with their experience and expertise.
Furthermore, a small market drop can be heavily magnified. And if you’re in a long position and trading with higher leverage, you may need risk management strategies, such as stop-loss orders. While there are other techniques you can employ, the basic rule is this: always invest what you can afford to lose.
Ready to trade in margin?
Margin trading is an effective tool to keep your capital input low while maximising profits. Keep in mind, though that losses are always possible. You have to understand all the risks involved in trading, like all endeavours you get into.
When executed right, margin trading can be a successful long-term strategy. Your broker has a crucial role in your Forex trading journey and can help you understand more about margin trading.