What?s With Forex Margins?

Posted by Nick Niesen on October 29th, 2010

Buying on margin is almost a necessity in the Forex (Foreign Exchange market) because the standard transaction is $100,000 and known as a ?lot?. Lots have to be that big on the Forex because of the sheer volume of money changing hands?nearly $1.8 trillion dollars every day (and the market is open 24 hours per day, Sunday through Friday). This huge volume is a large draw for investors along with other advantages, such as:

?Large volatility means great opportunity for profit
?Large volume means market is liquid and easy to enter/exit a position
?Ability to profit whether the market is rising or falling
?Stops and other account instruments can limit risk while ensuring maximum profitability
?Opportunity for commission free trades

It?s simple: The greater the risk, or volatility, the greater the potential for profit. In truth, retail or smaller Forex investors could not even play on the Forex market until rather recently. Prior to that, only investment banks, hedge funds, and really big investors could even trade on the Forex. Without leveraging accounts (or trading ?on margin?), there is no way that the average investor could afford to trade.

Now although the average Forex transaction is called a lot and $100,000, there are brokers that permit investors to trade ?mini-lots? for $10,000 and some even offer ?micro-lots?. However, the typical transaction is a lot and the typical investor would need to put up $1,000 in order to acquire a position, or 1%. Brokers and trading institutions need to have some kind of collateral in case of loss. For retail Forex traders, that collateral is the 1% margin put up to acquire the position. The broker will credit the trading account with this margin and secure it in the event of any future trading losses.

Because of the large minimum trading amounts, leveraged trading is simply a practical necessity for the retail Forex trader. However, because investment banks and other similar institutions must guarantee the loans used to leverage your trade?there is naturally an interest charge to factor into the transaction. While margins do allow smaller investors to realize the huge profits available in the Forex, they tend to enhance the rates of loss while adding a systemic cost to the process.

Leveraged financing, however, is the backbone of the new Forex and definitely has helped to fuel its trade volume. It is not common for losses to create a negative account because most brokers will close out an account once the margin has been used. However, losses will mount quickly in such a volatile market which is why all investors are advised to place stops with their orders. If stops are not placed and the account is not set up to zero out when the margin has been used, it is possible to incur losses all the way up to the size of the transaction, or $100,000 in most cases.

It definitely scares some investors to think about the potential for loss when leveraging a position. However, by simply setting stops in place, the potential for dramatic loss is contained while still allowing the investor the potential for unlimited profits. Forex margins are a reality for retail traders but there is nothing to worry about so long as you set your account up properly and put stops in place.