Trading on Margin
What is Margin?
Margin investing is a borrowing method by which a forex investor can trade currencies at higher volume than he would be able to on his own. The intuition is simple: A forex investor sees an opportunity in the currency market that no one else does and wants to capitalize on this information. Ordinarily he would only be able to trade the money that he has in his forex account; however, if he is particularly confident that his investment will yield big returns based on shifting exchange rates, then he might want to borrow the extra money from hisforex broker.
By definition, trading on the margin for a particular currency trade is the equity percentage the trader must have (in the originating currency) with his broker in order to make a currency exchange.
Margin Trading Example
Let's give an example. Suppose the trader has USD 5,000 in his account and has a margin capacity of 5%. The margin capacity reflects the minimum equity percentage that the trader is allowed to maintain. This means that the trader is allowed to trade a maximum of USD 100,000 in foreign currency by borrowing the remaining USD 95,000 from his broker.
Phrased differently, the 5% capacity means that the trader can trade at up to twenty times the value of his portfolio. The borrowed money required to reach the trading limit is usually interest-free short-term credit, and the total trading transaction is used as collateral for the loan.
It is clear that trading on the margin is only for the most risk-loving investors. While the loans that most brokers give are interest-free on short-term horizons, a forex trader can easily fall into heavy debt if the currency he trades into devalues.
Let's return to the previous example, and suppose that the trader decides to buy JPY. Suppose further that he buys USD 100,000 worth of JPY at an exchange rate of JPY 100/USD 1. This would put him at JPY 10,000,000. Consider a situation where the broker's loan horizon is one month and economic turmoil in Japan leads to a devaluation of the JPY over the ensuing month, leading to an exchange rate of JPY 150/USD 1. The investor now must pay back the USD 95,000 that he originally owed, but the value of his holdings in USD is only USD 66,666.67. So he is in debt by an amount of USD 28,333.33.
Clearly, there is also the opportunity to make a lot of money through margin trading if interest rates tip in one's favor. The basic idea is that trading on the margin allows one to magnify one's possible gains and losses by borrowing the extra equity required.
Phrased differently, the 5% capacity means that the trader can trade at up to twenty times the value of his portfolio. The borrowed money required to reach the trading limit is usually interest-free short-term credit, and the total trading transaction is used as collateral for the loan.
It is clear that trading on the margin is only for the most risk-loving investors. While the loans that most brokers give are interest-free on short-term horizons, a forex trader can easily fall into heavy debt if the currency he trades into devalues.
Let's return to the previous example, and suppose that the trader decides to buy JPY. Suppose further that he buys USD 100,000 worth of JPY at an exchange rate of JPY 100/USD 1. This would put him at JPY 10,000,000. Consider a situation where the broker's loan horizon is one month and economic turmoil in Japan leads to a devaluation of the JPY over the ensuing month, leading to an exchange rate of JPY 150/USD 1. The investor now must pay back the USD 95,000 that he originally owed, but the value of his holdings in USD is only USD 66,666.67. So he is in debt by an amount of USD 28,333.33.
Clearly, there is also the opportunity to make a lot of money through margin trading if interest rates tip in one's favor. The basic idea is that trading on the margin allows one to magnify one's possible gains and losses by borrowing the extra equity required.
Taking Advantage of Higher Margin
Having finished some of the basics, the reader might now be wondering how what we've been talking about differs from margin trading in the stock market. There are some differences in the types of margin trading in the two markets. The main difference is that brokers normally only allow investors to trade at up to two times the value of their accounts (i.e., traders are only allowed to trade at as low as 50% capacity). There are also maintenance margin requirements in stock trading. That is to say that if the investor's stock value at any point devalues to the point where the investor's equity plummets below 30%, the broker immediately demands payment from the broker. This maintenance margin in enforced in part to protect both parties from a situation where the trader accumulates more debt than is manageable.
Clearly while margin trading (in any market) has potential for great gains, it does not come without increased risk. This form of investing is only for the seasoned, risk-loving trader. One might add as a side note margin trading canbecome a gigantic problem for the market as a whole, not just the individual debtor, when whole swathes of people default on their creditors. Looking back to the prototypical example, the defaulting of a bevy of margin traders in the 1920s led to a widespread selling epidemic in U.S.stock markets, ultimately spurring the Great Depression.
Clearly while margin trading (in any market) has potential for great gains, it does not come without increased risk. This form of investing is only for the seasoned, risk-loving trader. One might add as a side note margin trading canbecome a gigantic problem for the market as a whole, not just the individual debtor, when whole swathes of people default on their creditors. Looking back to the prototypical example, the defaulting of a bevy of margin traders in the 1920s led to a widespread selling epidemic in U.S.stock markets, ultimately spurring the Great Depression.
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