The overall success of the FOREX market is made possible today because of margin. Without this important principle, the average investor would not be able to participate in FOREX at all. So what is margin exactly?
1. Trading On A Margin
In order to trade on a margin, you must set up a margin account. With a relatively small deposit, you can start trading large amounts of currency. Establishing a margin account with a FOREX broker enables you to borrow money from the broker to control currency lots that are usually worth $100,000. The amount of borrowing power your margin account gives you is the leverage. 100 – 1 means that with a single dollar you can control $100 worth of currency.
2. Increased Profits Also, Losses
As you might be able to extrapolate, you will be able to control $100,000 with just a $1,000 investment. Of course, you are borrowing money from the broker in order to do this, and any slip-ups can end up costing you big time. The potential exists for the trader to lose more than his original deposit. Usually, brokers will terminate a transaction that extends beyond the margin deposit.
With exponential buying power, your potential for more profits exists. FOREX currencies are traded in much smaller units than cash. The American dollar, for example, is traded in units down to 4 decimal places. Instead of $1.32 FOREX quotes are seen as $1.3256. The smallest unit in FOREX currencies is called the pip. Even a small change from 1.3256 to 1.3356 represents a difference of $100.
You have to be extremely careful when working on a 1% margin account. A currency change in even a penny can lose your entire $1,000 investment, but if the opposite is true you can stand to make $10,000 dollars from one penny.
5. Limiting Your Losses
To limit your losses, you might want to set up a stop-loss order. Stop-loss orders automatically close your position if the value of the currency crosses a pre-determined point. One risk that is often overlooked is your broker closing your account on you. This can be potentially disastrous if the currency you invested in suddenly rises in price and you are unable to sell.