Trading with margins is very much like a double edge sword. It can cut two ways since it can maximize your profits when the price moves favorably to your established position or magnify your losses if you happen to be on the other side of the fence.
Many forex traders lose money because they tend to recklessly disregard this trading reality. A lot of them focus only on the potential profit that a 50:1 leveraged trading has to offer putting a blind eye to the possibility that it can work the other way around.
Here is an illustration of how it can cut both ways:
Suppose you bought $100,000 (1 tranche or lot) worth of the British Pound (GBP) with a marginal deposit of $2,000 at the current rate of 1.5677 USD to 1 GBP and the price went up by 50 pips to 1.5727 USD to 1 GBP and you closed the position, the profit will be calculated as follows:
Profit/Loss = {[$100,000/Buying Price] – [$100,000/Selling Price]} x Current Price
or,
Profit/Loss = {[$100,000/1.5677] – [$100,000/1.5727]} x 1.5727
Profit/Loss = {63787.71 -63584.91} x 1.5727
Profit/Loss = $318.94
Now suppose the rate went down instead of going up by 50 pips from 1.5677 to 1.5627, using the same formula, here is what we will get:
Profit/Loss = {[$100,000/Buying Price] – [$100,000/Selling Price]} x Current Price
Profit/Loss = {[$100,000/1.5677] – [$100,000/1.5627]} x 1.5627
Profit/Loss = {63787.71 -63991.80} x 1.5727
Profit/Loss = – $320.97
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Clearly, you can see that if the market moves in your favor you stand to gain substantial profits but it can work the other way around if the price moves against you. On an ordinary day, the average fluctuation the exchange rates of major currencies is 100 pips but it can range from 200 to 500 pips on very volatile markets and in the presence of a high impact market moving news like an unexpected rate cut or rate increase.
Using the above formula, you can imagine how big a profit you can generate from a 500-pip price movement in your favor with this kind of leverage. However, you should not forget how much it could also burn a hole in your account if the price moves the other way around. The leverage that comes with margin trading can be a blessing and a curse and this is where essentially the risk lies.
To ensure that the foreign currency market remains efficient, i.e. profits are paid all the time, the margin trading system comes with a safeguard known as margin call. Every time a trader initiates a trade the margin call point is immediately calculated. As the rates of exchange fluctuate, the value of your account or your account balance also fluctuates.
It increases or decreases in value depending on whether the price is moving your favor or not. A margin call point is the price level where your account balance has depreciated and is just equivalent to 25% of the required margin. This means if the required margin is $2,000 and the price has gone against you such that your current account balance is down to $500 (25%) you have now reached your margin call point and the broker will automatically close your account at a loss whether you like it or not.
So, apart from the fact that leverage can work against you, you also need to avoid getting into margin call situations. These are the harsh realities of retail forex trading which every trader must be aware of. And he can only do so if he has a clear grasp of what margin trading is all about and the implication of leverage to his account especially when the price is currently going against your established position.