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Understanding Margin
Our Partner GAIN Capital margin policy is built on the principle of offering maximum flexibility to its customers.
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Understanding margin trading |
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What Is Margin Trading?
Trading currencies on margin lets you increase your buying
power. Here's a simplified example: If you have $2,000 cash in
a margin account that allows 100:1 leverage, GainCapital offers a contract worth 100k units of a currency-because you only
have to post 1% of the purchase price as collateral. Another
way of saying this is that you have $200,000 in trading buying power.
What are the benefits of margin?
With more buying power, you can increase your total return on
investment with less cash outlay. To be sure, trading on
margin magnifies your profits AND your losses.
Here's a hypothetical example that demonstrates the upside of
trading on margin:
With a US$5,000 balance in your margin account, you decide
that the US Dollar (USD) is undervalued against the Swiss
Franc (CHF).
To execute this strategy, you must buy Dollars (simultaneously
selling Francs), and then wait for the exchange rate to rise.
The current bid/ask price for USD/CHF is 1.6322/1.6327 (meaning
you can buy $1 US for 1.6327 Swiss Francs or sell $1 US for
1.6322)
Your available leverage is 100:1 or 1%. You execute the trade,
buying a one lot: buying 100,000 US dollars and selling
163,270 Swiss Francs.
At 100:1 leverage, your initial margin deposit for this trade
is $1,000. Your account balance is now $4000.
As you expected, USD/CHF rises to 1.6435/40. You can now sell
$1 US for 1.6435 Francs or buy $1 US for 1.6440 Francs. Since
you're long dollars (and are short francs), you must now sell
dollars and buy back the francs to realize any profit. Conversely if the market went against your expectations you would have to be closing your trade at a Loss.
You close out the position, selling one lot (selling 100,000
US dollar and receiving 164,350 CHF) Since you originally sold
(paid) 163,270 CHF, your profit is 1080 CHF. If the market went agaist you ex: below your entry point of 1.6327 you would have to sell your USD ata Loss.
To calculate your P&L in terms of US dollars, simply divide
1080 by the current USD/CHF rate of 1.6435. Your profit on
this trade is $657.13
SUMMARY
Initial Investment: $1000
Profit: $657.13
Return on investment: 65.7%
If you had executed this trade without using leverage, your
return on investment would be less than 1%. And if the trade was executed and the market went against you below 1.6327 for example to 1.6219 and you had closed your trade you would have lost 1080 CHF or $657.00 usd or 65.7% of your investment. “Increase Leverage Increases Risk.”
Managing a Margin Account
Trading on margin can be a profitable investment strategy, but
it's important that you take the time to understand the risks.
You should make sure you fully understand how your margin
account works. Be sure to read the margin agreement between
you and your clearing firm. Talk to your account
representative if you have any questions.
The positions in your account could be partially or totally
liquidated should the available margin in your account fall
below a predetermined threshold.
You may not receive a margin call before your positions are
liquidated.
You should monitor your margin balance on a regular basis and
utilize stop-loss orders on every open position to limit
downside risk.
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Risks and rewards trading on margin |
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All the aforementioned forex instruments are margin products, which means that your investment exposure can be
a multiple of the cash that you lay down (i.e. the margin).
The main advantages of margin are that:
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Margin enables private investors to trade in markets with high minimum units of trading (e.g. the spot market where the minimum size trade is 100,000 units of the base currency).
- Margin trading enhances the rate of profit or loss.
The principal disadvantage of margin trading is that it has the habit of inflating rates of loss, on top of systemic risk. For example, currency options are inherently riskier than
spot market trades, because a small change in the underlying spot rate can generate a disproportionately large change in options prices. Sell naked call options and there is no limit
to potential losses. Add leverage to the cocktail and you have the potential for large profits and large losses.
“Increase Leverage Increases Risk.”
"Forex trading involves substantial risk of loss and is not suitable for all investors."
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