What A Forex Margin Means To Currency Traders
To better explain a forex margin, the concept of margins in general should be explained. The rules for a forex margin are for the most part, applicable in other kinds of transactions with margins other than foreign exchange. The inverse is also true.
A margin (also called leverage because it amplifies purchasing ability, akin to a lever amplifying force) is collateral that one puts up in order to secure an investment or something similar. The collateral put up is usually less than the actual price of the investment. For instance, you may put up $100,000 for a piece of land that is valued at $500,000. Now suppose that there are developments around that piece of land that push its value up to $600,000. If you decide to sell, that would mean you made a full (100%) return on your investment of $100,000 dollars, since the value of the land appreciated by the same amount. If the value of the land was pushed up to only $550,000 and you sell, you make only a 50% return. If it appreciated to $700,000, you make a 200% return.
For purposes of trading, the ratios of margins, including a forex margin, are determined by whatever the market forces allow. For forex trading, this is usually at 100:1, though this is not the rule by any means.
The most appealing aspect of purchasing at margin in forex trading is that it would allow one to control a large amount of currency by putting up just a fraction of the market value of the amount. In other words, buying power is greatly increased when buying forex at margin. Usually however, forex market makers use some form of automatic control to freeze leveraged amounts when the returns on margins become negative. This is necessitated by the fact that currency markets in this era are particularly volatile and fast changing, due to all the actors and technology involved. To remedy this, traders will often put additional money in the account holding the forex margin. The way this works is, whenever the leveraged amount gives back negative returns, the losses will be deducted from the amount in excess of the margin. Let us suppose that your forex margin is at 100:1 for $1,000. That would mean that the forex margin or the amount you use to leverage the $1,000 is just at $10. To keep control of this amount when the returns are negative, you put in an additional $10. So whenever the leveraged amount of $1,000 decreases in value against another currency the corresponding loss is deducted from the extra $10 dollars you put up. This ensures that you maintain control of the leveraged amount. The main disadvantage of a forex margin should be obvious at this point. While purchasing currency at margin can greatly increase your ability to buy, it can considerably amplify your losses as well, which is why there are automatic controls in the first place, though these are not always present. At the end of the day, buying foreign exchange at margin can be a very appealing, though somewhat tricky proposition for currency trader. Generally, currency markets are very highly leveraged. In light of this, the need for a forex margin when trading for currencies should be studied and considered by every prospective trader.
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