In the Forex world, brokers allow trading of foreign currencies to be done on margin. Margin is basically an act of extending credit for the purposes of trading. For example, if you are trading on a 50-to-1 margin, then for every $1 in your account, you are able to trade $50. This has both its drawbacks and advantages.
- In margin trading, your trading account is extended credit to increase its trading value.
- When you trade on margin, each dollar in your account is worth more in a trade than it is at face value.
- This method creates the possibility for huge gains but also significant losses.
- Margin trading is best for experienced traders who have a clearly defined risk management policy.
Advantages of Trading on Margin
The advantage of trading on margin is that you can make a high percentage of gains compared to your account balance. For instance, let's assume that you have a $1,000 account balance and you are not trading on margin. You initiate a $1,000 trade that nets you 100 pips. In a $1,000 trade, each pip is worth 10 cents. The profit from your trade would be $10 or a 1 percent gain. If you were to use that same $1,000 to make a 50-to-1 margin trade giving you a trade value of $50,000, the same 100 pips would net you $500, or a 50% gain.
Disadvantages of Trading on Margin
The disadvantage of using margin is the risk. Let's make the opposite assumption that we made while discussing advantages. You are still using a $1,000 account balance. You initiate a $1,000 trade and lose 100 pips. Your loss is only $10 or 1%. This is not too terrible, you would have plenty of capital left to try again. If you were to make a 50-to-1 margin trade for $50,000 a loss of 100 pips takes $500 or 50% of your capital. One more trade like that and your account is finished. In the first example, you only lost $10 and you could make that same losing trade 99 more times before your account was empty.
Learn How to Use It Right
Please keep in mind that what is held in margin isn't available as a cushion on losing trades. A common differentiator between winning and losing traders is the amount of capital they have in their account and how much of their account do they tie up in margin, which significantly reduces the margin of error afforded to them.
It helps to think of a trade much like you would a deposit. Once the trade is closed, you get the deposit back, however, when you're in the trade, the deposit or margin is locked up.
The Bottom Line
Margin trading is just another tool. You can use it to make impressive gains and simultaneously risk excessive loss. Trading on margin effectively is best done with a reasonable amount of experience and a strict risk management policy.