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Margin and Leverage

Without proper risk management, the high degree of leverage can lead to large losses as well as gains

Additionally, Forex trading with us is done on a margin system, essentially using a free short-term credit allowance used to purchase an amount of currency that greatly exceeds the traders account value

Understanding the Margin System

Trading currencies on margin lets you increase your buying power. Here's a simplified example: If you have $2,000 cash in a margin account that allows 1:100 leverage, you could purchase up to $200,000 worth of currency-because you only have to post 1% of the purchase price as collateral. Another way of saying this is that you have $200,000 in buying power.

You are probably wondering how a small investor can trade such large amounts of money. Think of your broker as a bank who basically fronts you $100,000 to buy currencies and all he asks from you is that you give him $1,000 as a good faith deposit, which he will hold you for but not necessarily keep. Sounds too good to be true? Well this is how forex trading using leverage works.

For example, for every $1,000 you have, you can trade 1 lot of $100,000. So if you have $5,000 you can trade up to $500,000 of Forex.

In the example above, it is used a one percent margin. This means that for every $100,000 traded, the broker wants $1,000 as a depost on the position.

What is a Margin Call ?

In the event that money in your account falls below margin requirements (usable margin), your account will close some or all open positions. This prevents your account from falling into a negative balance, even in a highly volatile, fast moving market.

Example #1
Letís say you open a regular Forex account with $2,000. You open 1 lot of the USD/JPY, with a margin requirement of $1000. Usable Margin is the money available to open new positions or sustain trading losses. Since you started with $2,000, your usable margin is $2,000. But when you opened 1 lot, which requires a margin requirement of $1,000, your usable margin is now $1,000.
If your losses exceed your usable margin of $1,000 you will get a margin call.

Example #2
Letís say you open a regular Forex account with $10,000. You open 1 lot of the USD/JPY, with a margin requirement is $1000. Remember, usable margin is the money you have available to open new positions or sustain trading losses. So prior to opening 1 lot, you have a usable margin of $10,000. After you open the trade, you now have $9,000 usable margain and $1,000 of used margin.
If your losses exceed your usable margin of $9,000, you will get a margin call.
Make sure you know the difference between usable margin and used margin.

If the equity (the value of your account) falls below your usable margin due to trading losses, you will either have to deposit more money or the system will close your position to limit your risk. As a result, you can never lose more than you deposit.

Leverage Ratio and Margin Percentage

The simple relationship between the two terms are:

Leverage = 100 / Margin Percent
Margin Percent = 100 / Leverage

Leverage is conventionally displayed as a ratio, such 1:100

Margin Trading: Stocks vs Forex

The word "margin" means something very different in forex than it does in stocks. With stocks, trading on margin means that a trader can borrow up to 50% of a stock's value to buy that stock. This can be a costly move because the investor must pay interest to the brokerage firm on the amount borrowed. This is not the case in forex trading.

For example: at $400/share, 100 shares of Google are valued at $40,000 ($400 x 100 shares). To trade this stock on margin, the money required for the trade is 50%, or $20,000. The remaining $20,000 is borrowed and interest must be paid on that amount. Margin interest is different from broker to broker, but a good rule of thumb is typically Prime plus 1-3% or more.

In forex, margin is the minimum required balance to place a trade. When you open a forex trading account, the money you deposit acts as collateral for your trades. This deposit, called margin, is typically 1% of the value of the position.

For example: if you want to purchase $100,000 of USD/JPY at 1:100 leverage, the money required is 1%, or $1000. The other $99,000 is collateralized with your remaining account balance. You pay no interest.

It is very important to remember that leverage magnifies your profits AND your losses. You should monitor your account balance on a regular basis and utilize stop-loss orders on every open position to limit downside risk.

However, leverage is an exceptionally good tool that can be utilized to increase your buying power and return on capital, as long as you have a solid risk management plan in place.

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