Lesson

Understanding Margin Trading

Margin trading refers to the practice of using borrowed capital from a broker to trade a financial asset. The capital serves as collateral for an effective loan from the broker. In the event of a loss, the broker can make a “margin call” by closing out open trades without prior consent from the trader/client. 

With BDSTrading, all clients are guaranteed their accounts cannot fall below zero. All margin calls are done automatically via MetaTrader in accordance with our trading conditions.

Importantly, the designated margin is not a cost or a fee – it is merely a portion of the customer’s account balance that is set aside for trading purposes.

Margin in Foreign Exchange

Trading anything can be done in multiple ways, with a variety of objectives, expectations and outcomes. Some traders choose to speculate in the short term, others are looking to invest for the long term.

Primarily a part of speculative trading, margin trading, otherwise known as “leverage”, plays a huge role in a trader’s strategy. 

Leverage has made it possible for individual people to speculate on the financial markets, even with comparatively small levels of funding. Not so long ago, only specialised firms or extremely wealthy individuals were able to speculate on the movements of currencies, equities and commodities. Not anymore.

Leverage has made it possible for individual people to speculate on the financial markets, even with comparatively small levels of funding. A trader who wants to trade $100,000 in nominal currency with a 1% margin requirement, would have to deposit $1,000 while the remaining 99% is provided by the broker. In a margin trading account, the $1,000 serves as a security deposit.

How leverage works in practice

Suppose a new trading account is opened and funded with $500. Let us also assume the margin requirement is 1%, making the leverage on this account 100:1.

Through leverage, margin trading accounts allow traders to artificially increase the purchasing power of their initial deposit to the point of the initial $500 deposit becoming closer to $50,000 (100:1 leverage) when placing a trade. This means that the trader can potentially buy or sell approximately $50,000 in nominal currency. 

Suppose the trader decided to buy 0.1 lots ($10,000) in GBP/USD at a price of 1.5000. This would use up 20% of the trader’s total margin capacity and mean that the trader is earning (or losing) close to $1 for every pip of price action.

If GBP/USD were to rise from 1.5000 to 1.5100 (a 100-pip move), the trade would generate a profit of $100. Conversely, if GBP/USD falls from 1.5000 to 1.49000, the trade would generate a loss of $100.

Leverage beware

Leverage magnifies the outcomes of your trades which means margin trading accounts are a double-edged sword: a tool that can deliver both favourable and unfavourable outcomes, depending on the prudence of the trader.

Taking this into consideration, it’s important to understand that leverage, in and of itself, is not the undoing of novice traders, but rather, its misuse in relation to their account balance.

Leverage magnifies outcomes, but most beginners prefer to think about the potential magnified winnings rather than the potentially magnified losses. 

It is human nature after all, but a nature that should be consciously mitigated to ensure a disciplined approach to risk-taking. Leverage should only be utilised insofar as it does not breach your core risk limits within your trading strategy.