A fascinating thing about forex trading is the ability to trade with margin. Almost all forex brokers offer margin accounts to their clients. It provides excellent benefits to traders.
Many Forex traders take the concept of ‘margin’ for granted. Particularly in forex margin accounts, there is stuff like balance, used margin, free margin, unrealised P/L, Equity, margin level, etc. which is not understood by the majority of the forex traders. But, as a trader, it is vital to understand this margin jargon.
So, let’s begin the mini-course by first understanding the basics of a margin account.
What is a Margin Account?
A margin account is a type of trading account offered by brokers in which they lend their customers cash to purchase any financial asset. So, traders get the ability to take positions larger than their actual account balance.
To get started, traders must first sign up to a forex broker. After finding the right broker, they must set up a margin account. In this account, the trader takes a short-term loan from the broker. This loan is basically the leverage taken on by the trader.
To start placing trades, a trader should deposit some money into their margin account. The amount to be deposited depends on the agreed margin percentage between the trader and the broker. Usually, the margin percentage is either 1% or 2%.
For instance, if a trader wants to take a position worth $100,000 and his margin percentage is 1%, then he must deposit 1% of the value he wants to trade. I.e., he should deposit $1,000 into his margin account, and, the rest 99% will be provided by the broker. In other terms, it is also referred to as 1:100 leverage. Note: Both margin and leverage mean the same.
No interest is paid directly on the borrowed amount initially. But, if the trader holds the positions beyond the delivery date, then the position will be rolled over. In the latter case, interest may be charged based on the investor’s position and the short-term interest rate of the currency.
Furthermore, in a margin account, $1,000 is used as some sort of security deposit. So, if the investor’s position goes into the negative and approaches a loss of $1,000, the broker can initiate something called “margin call.” When a margin call happens, they can close the position without the consent of the investor.
Pros and Cons of Margin Trading
1.- More power in your hands
As obvious as it gets, the most significant advantage of margin trading is that it lets you control larger positions with a minimal amount of investment.
2.- Exponential growth
Since you will be dealing with bigger positions, you can grow your account size exponentially.
3.- Room for diversity
With the help of the margin provided by brokers, you can take positions in different currencies even with small account sizes.
1.- Increased risks
Though you can grow your account size exponentially, it does not mean that your risk reduces along the way. Note that profit and loss go hand in hand. That is, bigger the profits you aim for, bigger becomes the risk.
2.- Mental stress
This goes more with psychology in trading. Once people are in a trade, they forget their analysis and begin to focus on the running profit/loss. This mental state brings emotions in the middle of their trade, which eventually makes them make decisions based on emotions.
From this, we can conclude how important it is to understand the concepts behind margin trading. Hence, in the coming lessons, we shall be going through more details about it.