Among online forex brokers, the term margin refers to the amount of liquid funds that a trader needs to hold on deposit with them in order to control a given size trading position. Trading on margin provides a forex trader with the leverage to control larger positions than they could otherwise usually afford.
Many traders from other financial markets, as well as novices and gamblers, seem very attracted to the exceptionally high potential for trading on margin and the resulting high leverage ratios available to forex traders using online forex brokers.
Nevertheless, such unwary traders tend to blithely focus on the brighter side of margin trading that offers higher profits if they are correct in calling the direction of the forex market. In contrast, the more prudent and experienced traders are usually painfully well aware of the higher potential for losses that trading on margin has, as well as how unpredictable the often volatile forex market can be at times.
It therefore makes good sense to understand thoroughly the risks involved in trading forex on margin before allowing its use to amplify excessively the already considerable risks involved in trading forex to the ultimate detriment of your online trading account.
How Margin Works in Practice
In practice, if $100 of margin placed on deposit with an online forex broker is required to control a $10,000 mini lot in an online trading account, then that would be considered a leverage ratio of 100:1. Basically, that leverage ratio means that $1 of margin can control $100 worth of a trading position.
Furthermore, such a 100:1 leverage ratio would also imply that $10 of margin is needed to control a smaller micro lot of $1,000, while $1,000 of margin could control a larger $100,000 standard lot.
Some Advantages of Trading on Margin
Trading forex on margin can give you some advantages when wisely managed. Some of these might include:
- Risk of Profit is Magnified – Using the leverage that margin provides generally increases the risk you take on each trade. This can be a good if the trade results in a profit, and the judicious use of margin does allow a less well funded trader to take more risk when they feel especially confident in a trade’s potential success.
- Broaden Diversification – By not having to tie up all of your trading capital in establishing one position, you can increase the diversification in your forex portfolio and trade several currency pairs at the same time.
- Add to Profitable Trades – Trading on margin means you can often set aside some extra trading capital to allow you to add another trade to an already profitable transaction in an appropriate use of a scaling strategy.
Some Disadvantages of Trading on Margin
Trading forex on margin also has some disadvantages that can arise and cause potentially costly account draw downs. Some of these issues can include:
- Risk of Loss is Magnified – The higher risk involved in trading on margin can mean bigger losses, which can in turn throw off your risk management strategy and cause a blow out in your online trading account.
- Account Blowouts – The unexpected often happens in the forex market, as news stories hit, central banks intervene or major economic data surprises the market. These events can cause traumatic and unexpected movements in forex rates that can easily blow out an unsuspecting margin traders’ account that gets inadvertently caught on the wrong side of the market. The phenomenon of order slippage means that blowouts can happen even if the margin trader prudently placed stop loss orders with their currency brokers.
- Liquidation Risk – Online forex brokers often initiate the liquidation of positions when a trader has insufficient funds deposited in their online trading account as margin. As a result, a trader might have their positions closed out at the worst possible time from a loss standpoint, when the trades might ultimately have been profitable if the trader had utilized less leverage.