This is a continuation of my planned series of posts on the Foreign Exchange Market. The last time, I focused on mandatory Forex Risk Warnings; this time, let's take a look at the "devil" called margin trading.
Margin or leveraged trading accounts allow trading in an asset (for example, forex or stocks) at a multiple of your own capital. In effect, if an account allows a margin of up to 100:1 (a margin requirement of approximately 1%), with $1,000 of equity, you will be able to hold (more or less) a position of up to $100,000 of the asset being traded.
Sounds great doesn't it? Don't be fooled. Trading on margin is not for beginners or the feint at heart. It can make grown men cry! It's an enticing and irresistable invitation from the devil that can bring pain unimaginable. $1,000 gives command of $100,000, so any favourable movement in price means magnified earnings on the extra amount invested.
Borat would say, "nice, very nice"! However, do not plan that luxury trip just yet. You will want to know that the converse is also very true...too real in fact. If price movements are unfavourable, it means losses of approximately 100 times the amount you would have sustained if you were trading just the capital on the account.
It may sound like a reasonable 50/50 proposition but think again. Given the level of difficulty associated with forex trading which sometimes, unfortunately, is not very apparent, it's highly likely that the latter will happen. If you are lucky and the price moves favorably, it may even be worse. Think of it as the "kiss of death" that is luring you to the ultimate doom. Sounds scary...but it's true. Be warned!
Just some other useful information: When trading margin, be sure to understand fully how your brokerage account operates. If the Broker allows a margin of 100:1 with trading lots of $100,000, then it means that you will need more than $1,000 of equity to trade effectively. With $1,000, you can take a position of $100,000; but if the initial price movement is unfavourable, you would have breached the capital requirements of the account and 'stopped out' by the dreaded "margin call".
Margin call? Yes, margin call. If prices eat away your equity below the Broker's margin requirement (in this case 1%), the trading platform will automatically close your account until fresh funds are added to bring the account back into compliance. So, as I said...just more useful information. Always bear in mind the capital or equity required by the Broker, in addition to a buffer to protect against unfavourable price movements.
Finally, given the high risk of loss associated with margin trading, it is advisable to trade a Demo Account while testing various trading strategies to find one that works for you. Only switch to a "live" account when you are totally at home with, among other things, the concept of margin trading.
Very importantly, always bear in mind that trading with just your equity or reducing the amount of leverage are alternatives to trading using the full margin allowed and sure ways to resist the temptation of the devil, while preventing huge losses. Good luck!