The Forex market is exciting and accessible to small retail traders because of the industry’s high leverage options. Leverage gives a trader the ability to increase the potential return on an investment.
*Leverage works both ways however; it increases potential returns, but it also increases potential risk. Therefore leveraging magnifies both gains and losses.
Leveraging a position involves putting down collateral, known as margin, to take on a position that is larger in value.
How is this possible? In the Forex market, when trading the established currencies, the amount that a currency changes in any given day is quite small. A one cent (or approximately 100 pip) change in the value of a currency is considered a large move. Therefore we can afford to hold a fairly small amount of collateral for any given position.
For example let’s take a trader with $1,000 in his account. Our trader buys 1 lot of EUR/USD at a price of 1.2750 with the 400:1 maximum leverage. His utilized margin is $250. If the position makes money, the gains are added to the equity in the traders account. Likewise if the position goes against the trader the losses are subtracted from the account’s total equity. If the price moves 100 pips in the trader’s favor (the exchange rate moves upwards one cent to 1.2850), then the trader would make a $1,000 profit ($10 per pip × 100 pips). The trader has effectively doubled the size of his account, a 100% return on his $1,000 account or a 400% gain on his $250 margin. Conversely if the position had gone at least 75 pips against the trader, his position would have been closed due to a margin call when his account equity dropped below his $250 margin requirement. The trader would have a loss of approximately $750, or 75% of his initial account, and about $250 remaining in his account.
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Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetitie. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.
