Trading currencies on margin lets you increase your buying power. Here’s a simplified example: If you have $2,000 cash in an account that allows 200:1 leverage, you could purchase up to $400,000 worth of currency. This is because you only have to post 0.5% of the purchase price as collateral. Another way of saying this is that you have $400,000 in buying power.
Benefits of Margin
With more buying power, you can increase your total return on investment with less cash outlay. To be sure, trading on margin MAGNIFIES your PROFITS and your LOSSES.
Here’s a hypothetical example that demonstrates the upside of trading on margin:
Example – The upside of trading on margin:
With a US$5,000 balance in your Forex account, you decide that the US Dollar (USD) will increase in value relative to the Swiss Franc (CHF).
To execute this strategy, you must buy Dollars (simultaneously selling Francs), and then wait for the exchange rate to rise. This is easily done in the trading software – simply click on the USD/CHF exchange rate in the Trading Window, and select “BUY”.
Assume the current bid/ask price for USD/CHF is 1.2732/1.2735 (meaning you can buy $1 US for 1.2735 Swiss Francs or sell $1 US for 1.2732 francs)
Your available leverage is 200:1 or 0.5%. You execute the trade, buying one Lot of USD/CHF. That is, buying 100,000 US dollars and selling 127,350 Swiss Francs.
At 200:1 leverage, your initial margin deposit for this trade is $500. Note that your account balance is still $5,000 – the margin requirement is not “deducted” from your account, it simply must be available in your account.
As you expected, USD/CHF rises to 1.2815/18. You can now sell $1 US for 1.2815 Francs or buy $1 US for 1.2818 Francs. Since you’re long dollars (and are short francs), you must now sell dollars and buy back the francs to realize any profit.
You close out the position, selling one lot at 1.2815, realizing a $624 profit (profits are calculated automatically by the MetaTrader 4 software):
|Profit:||$624.27||Return on investment: 124%|
If you had executed this trade without using leverage, your return on investment would have been less than 1%.
Managing a Margin Account
Trading on margin can be a profitable investment strategy, but it’s important that you take the time to understand the risks.
You should make sure you fully understand how your margin account works. Be sure to read the margin agreement between you and your clearing firm. Talk to your account representative if you have any questions.
The positions in your account could be partially or totally liquidated should the available margin in your account fall below a predetermined threshold.
You may not receive a margin call before your positions are liquidated.
You should monitor your margin balance on a regular basis and utilize stop-loss orders on every open position to limit downside risk.