How to Understand the Forex Margin
Margin is a tool used by brokerage accounts to provide clients with access to more transactions than their cash holdings would allow. This benefits both brokers and investors. The investors can enjoy greater returns than would otherwise be available to them. Brokers in turn benefit from additional commissions that larger position sizing requires. However the losses also occur more quickly in the event of a downturn in an investment. Forex margin is particularly high-leveraged to provide traders with the opportunity to profit from minuscule changes in currency valuations. Before any Forex trader enters a speculative position in the value of a currency, they should understand the nature of Forex margin.
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Instructions
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Determine the leverage provided by the Forex broker. This usually requires a simple email or phone call to the broker. As of April 2010, U.S. law provides Forex brokers with up to 100X leverage for their clients. This means that a $100 trade would only require $1 in actual cash in the account. The leverage is even greater in other countries, such as the United Kingdom which provides 200X.
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Determine the minimum margin balance required by the broker for the currency valuation you wish to trade. This usually requires a simple email or phone call to the broker. For example, if you wish to speculate on the value of the euro against the dollar, this conversion rate may currently be 1.33. The broker usually rounds up to 1.5 to provide slack for changes in these rates. These numbers are frequently adjusted by brokers as currency values fluctuate. If the leverage is 100X, then the minimum margin balance for a single unit of trade in the euro/dollar transaction is $150, or 1.5 x 100.
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Divide your current cash holdings in the brokerage account by the minimum margin balance requirement for the currency you wish to trade. This number is the maximum number of Forex contracts you can purchase using the broker's margin rates. If you have a $3,000 account and wish to trade euro/dollar at $150 minimum margin per contract, then you can transact up to 20 contracts with your current account size. Without margin, this same transaction of 20 contracts would require $300,000 in cash.
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Tips & Warnings
The extraordinary leverage provided by Forex brokers makes it possible to profit from tiny changes in currency conversion rates. However losses add up quickly. It is possible to lose thousands of dollars within minutes if you use the full leverage and entire cash holdings of a margin account on a single trade.
References
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