Consider this as the first of a series of Forex Trading Tips we shall be sharing with you. Nope we shall not give you a list of do’s and don’ts. Rather, we shall touch on topics that are quite confusing in the minds of startup traders. The tips shall cover topics, which have not been delved at length in any forex training seminars or downloadable forex manuals, but are otherwise vital for beginners to have a clear understanding of. And the most appropriate topic to start is about margin trading or leverage trading.
Trading the currencies online is done using what is called as a margin trading system. This offers an advantage to traders as they are able to trade (buy or sell) currencies several times the amount of capital used. (We shall discuss this in detail later in this article.) Being able to trade big volumes using only a small margin is actually what attracts neophyte traders to foreign currency trading. Imagine being able to buy or sell $500,000 worth of foreign currencies with only $5,000 deposited in his trading account. This is a 1:100 leverage ratio and illustrates the power of margin trading. Leverage ratios can range from 1:50 to 1:400 depending who the broker is you deal with. In other words, with margin trading, investors are able to achieve more value for the money they invested.
By way of forex trading tips, however, it must be pointed out that margin trading is both a blessing and a curse to the traders. While it can amplify profits, it can also work in the reverse and amplify your losses just as fast and with the same magnitude. Simply put, margin trading gives you the opportunity to build up wealth fast but just as fast, you can also lose your shirt. Not understanding this implication of margin trading in foreign currency trading is where the risk lies.
Many novice traders close their eyes to the curse of trading on leverage and focus more on the huge profit potential profit they can get because of it. As a result, they fail to include exit strategies to protect their positions when they trade and the market happens to go against their positions.
With forex trading tips, it is necessary to point out that failure to appreciate the good and the bad side of margin trading can actually lead to more complications like incurring what is known as a margin call.
Traders who incur margin calls have perhaps very little understanding of the mechanism of margin trading. As a consequence, they fail to incorporate exit strategies in their trading plans thus allowing losses to roll and accumulate to a point where the broker automatically cuts his position automatically at a loss whether he likes it or not. That point is known as the margin call point and corresponds to a certain price level where the incurred losses decimated of the deposit to the extent that remaining balance unimpaired by losses is not less than 25% of the required capital for each outstanding lot.
Trading is done by lots in foreign currency trading and there is a margin requirement to trade each lot. In this case, if the required margin is $1000 per lot; then losses can be tolerated but only up to the point (margin call) where the unimpaired deposit (the remaining balance not tied to any loses) is not equal to or less than 25% of $1000 or $250.
Margin call is a protective mechanism that protects the investors and ensures obligations are met all the time. They are designed to keep the foreign currency market efficient. Unfortunately, the implications of margin trading including margin call are not being highlighted much less discuss at length by brokers or their agents. The novice traders get to learn many of such important aspects of foreign currency trading through other traders or through forex trading tips published online.