Most beginner forex traders don't really understand how trading on margin works. To them, margin is just a way to be able to trade bigger positions. However, there are many misconceptions that can prevent you from using it effectively.
Most beginner forex traders don’t really understand how trading on margin works. To them, margin is just a way to be able to trade bigger positions. However, there are many misconceptions about trading with margin that can prevent you from using it most effectively.
Margin represents borrowed money. This is a prevalent myth that stems from a misunderstanding of how margin works in forex trading. Margin in forex is actually known as a “performance bond” since it represents the amount of money you need to ensure that any losses you incur can be covered. To illustrate, let’s say you want to open a position worth $150,000. Since the margin requirement is 2%, you are required to deposit $3,000 in your trading account. This amount is intended to cover any losses that may result from your trading.
What about the $147,000? Is it not money borrowed from the broker? No, because when you are trading forex you are not actually buying or selling currency but just the agreements to do so. Thus there is no need to borrow actual money.
You can only cover margin requirements with cash. You can also open new positions that can be profitable in order to increase your margin. This is why the amount of capital in your trading account is known as equity, which is computed as the amount of cash plus profits from open positions less losses from open positions. This means that your equity is constantly fluctuating as currency values in the market change.
However, this can also be beneficial for you as, instead of making a margin call, the broker may simply close out some of your losing positions until the equity reaches the required margin again.
Forex trading is very risky because of the high leverage involved. While there is a certain amount of risk involved with currency trading, it is not as much as commonly believed. The reason is that regulators have capped the permissible leverage ratio that can be offered to US traders. Prior to 2010, traders could avail of leverage ratios of as much as 400:1, meaning that with as little as $100 in their trading account, they could open positions worth up to $40,000. Lately, however, US regulations have limited the leverage ratio to 50:1 even for brokers outside the US. This has substantially limited the amount of risk involved in forex trading.