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Forex Margin Explained – A Strategic Advantage In Forex Trading

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Introduction

 

 

In this lesson, forex margin will be explained in further detail – as you’ll learn how margin works when trading currencies, the benefits and risk of trading on margin, and how it can affect your trades.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Forex Margin Explained

 

 

Let’s start by looking at the units currencies are traded in.

Most currencies are traded in lots. The lot sizes vary depending on the amount of money an investor wants to devote to a position.

Most brokerages gives you the ability to trade in standard lots, mini lots, and micro lots.

A standard lot represents 100,000 units of a currency.

Mini lots represent 10,000 units.

And micro lots represent 1,000 units.

 

 

When trading currencies, you’re dealing with pips A Pip is a percentage of a point that actually extends four decimal places. This means you’re commonly dealing with one hundredths of a penny.

However, when trading YEN, JPY, a Pip only extends to the second decimal, 0.01.

Depending on the currency pair, a one hundredth of a penny with 100,000 units means each PIP is worth about $10.

For example, lets say the exchange rate for euros to US dollars is a ratio of 1.4.

In this case, 100,000 units means that 100,000 euros is the same as $140,000 US dollars.

Investing $140,000 may be difficult for some traders, which is where margin comes in.

 

 

When purchasing a lot in the forex market, you’re actually placing a good faith deposit known as a performance bond, but commonly called margin.

If you’re familiar with margin in stocks, margin in the forex market, is not much different.

 

 

When trading stock, the margin requirement is the amount of capital needed to enter into a position. The same is true for currencies.

Margin in the forex market is simply the amount of capital you need to open a position in a currency pair.

Trading on margin rates leverage, which can result in significant gains, as well as significant losses.

 

 

Forex can be split into two different categories, major pairs and minor pairs.

Major pairs, such as the US Dollar, Euro, and Yen, are more commonly traded, and the margin requirement can be as low as 2%, which results in 50 to 1 leverage.

So for every dollar you have on margin, you control about $50 in a trade.

As we stated earlier, this 50 to 1 leverage applies to certain major pairs – but minor pairs, like the Mexican Peso, Singapore Dollar, and Hong Kong Dollar are commonly 20 to 1.

These ratios can change. So talk with a forex trade desk to be sure you understand the leverage you’re dealing with.

Let’s go back to our example where 100,000 euros equaled $140,000.

How much would you need on margin to trade this pair?

 

 

Well, a 2% margin requirement is simply 2% of the total unit value. Therefore, your margin requirement would be $2,800.

On pairs where the US dollar is not included, the total unit amount will have to be converted to US dollars.

If you think about it, $2,800 isn’t a lot of money to control $140,000. This means it won’t take much for the pair to move against you and eat up your initial margin.

 

 

Let’s look at an example of this type of leverage.

Remember that when trading standard lots of 100,000 units, each pips movement equals about $10.

Therefore, a pair that increases 90 Pips could result in a $900 profit.

Of course, the opposite is also true, a decrease of 90 Pips could result in a $900 loss.

 

 

The leverage gain through margin is one of the biggest reasons traders trade the forex market – however, this is also why smaller lots maybe preferable.

Trading mini or micro lots might be more suitable for your trading goals and risk tolerance.

Mini lots represent 10,000 units with a PIP value of around $1. And micro lots represent only 1,000 units with each PIP worth about $0.10.

While these forex trades can be rewarding, there is also some risk because of the leverage.

So you should always have a well-defined plan when you’re dealing with margin that determines a clear exit. This way, if a trade doesn’t work the way you expect, you can limit the losses.

 

Quick Recap

Forex Margin

 

  • When purchasing a lot in the forex market, you’re actually placing a good faith deposit known as a performance bond, but commonly called margin
  • If you’re familiar with margin in stocks, margin in the forex market, is not much different
  • Margin in the forex market is simply the amount of capital you need to open a position in a currency pair
  • Trading on margin rates leverage, which can result in significant gains, as well as significant losses
  • Leverage for major pairs ( US Dollar, Euro, Yen, ect.) are much higher than that of minor pairs (Mexican Peso, Singapore Dollar, and Hong Kong Dollar, ect.)
  • The leverage gain through margin is one of the biggest reasons traders trade the forex market – however, this is also why smaller lots maybe preferable
  • Trading mini or micro lots might be more suitable for your trading goals and risk tolerance
  • Mini lots represent 10,000 units with a PIP value of around $1. And micro lots represent only 1,000 units with each PIP worth about $0.10
  • While these forex trades can be rewarding, there is also some risk because of the leverage
  • So you should always have a well-defined plan when you’re dealing with margin that determines a clear exit. This way, if a trade doesn’t work the way you expect, you can limit the losses

 

Types Of Lots

 

1. Standard Lots – represents 100,000 units of a currency

2. Mini Lots – represent 10,000 units of a currency

3. Micro Lots – represent 1,000 units of a currency

 

Measuring Forex Movements

 

  • When trading currencies, you’re dealing with PIPS. A PIP is a percentage of a point that actually extends four decimal places. This means you’re commonly dealing with one hundredths of a penny
  • However, when trading YEN, JPY, a PIP only extends to the second decimal, 0.01
  • Depending on the currency pair, a one hundredth of a penny with 100,000 units means each PIP is worth about $10

 

 

 

 

And this is forex margin, in its entirety. The underlying concept of trading on margin is exactly the same, regardless of what asset class you have chosen to trade (whether that is stocks, futures, forex, ect.)

it should be noted that major pairs offer a higher degree of leverage that of minor pairs. This also means that the trade off fits accordingly and all depends on the type of currency pairs that you would like to trade.

Using margin to trade forex allows you to control a significantly large amount of capital for a significantly lower cost – this can be an attractive margin for money conscious investors or traders.

Buying on margin simply mean that you have an agreement with your broker, in which your broker “loans” you the amount of capital you would like to trade to open a position on a currency pair – of course, this isn’t free – as you are obligated to buy back the same amount you borrowed from your broker again – sounds simple right?

The only catch is that if the price movement goes against you, you will be forced to buy back the amount you borrowed at a price greater than you have received them at – causing you to lose money in the process. When buying on margin, the potential for loss is unlimited, so this is more of an advanced strategy that should be used by professional traders only.

Luckily, all brokers require you to fill out an application first in order to have a margin trading account, so for most, this is not something that you have to worry about.

But as always, forex trading, like all derivative day trading, is extremely risky. This should only be used by advanced and sophisticated traders who have years of experience and expertise.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

 

 

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