Margin trading refers to the process of using borrowed capital to place a financial transaction, usually on the currency or currency futures markets. In forex, the more proper term might be “leveraged trading” as most brokerages firms refer to margin and leverage interchangeably. However, in the futures markets, it is more common to see “margin” used to describe the process of borrowing for an investment.
Investors use margin because the movements on the currency markets are very small, often less than 1% per day on any given pair. Even in the long-haul, currency pairs tend to trade for years within a trading range worth 20-50% the value of the currency pair. Making money without margin in such a small channel is almost impossible, since the probable returns from unlevered forex trades are in the low-single digits, and are quickly eroded by differences in inflation rates.
Margin and Forex
Recent changes to regulation have sought to stamp out the utility of margin on the currency markets, though US investors can still enjoy margin of up to 50:1 for major pairs, and 20:1 for exotic pairs. Fifty-to-one leverage means that to buy $100,000 (a full lot) of a USD denominated pair a trader would need put up only $2,000 of his or her money.
We’ll compare three scenarios to show the full effects of margin in the forex market:
- Currency pair rises 1% – If the example above were to come true, and an investor were to buy $100,000 in currency at 50:1 leverage, then a 1% change in the currency value would create a profit of $1,000 for the investor. Thus, the cash-on-cash return would be equal to 50% from a minor, one percent move in the pair.
- Currency pair falls 1% – If the currency pair falls by 1%, then the investor stands to lose $1,000 as one percent of $100,000 is $1,000. Keep in mind that since the investor put up only $2,000 of his or her money to complete the trade, their actual return is a negative 50%.
The leverage afforded to investors in the currency markets is a double-edged sword, one that can create both large percentage losses and large percentage gains. At the end of the day, however, the simple fact is that without margin trading, there would be very little reason to trade the forex markets.
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