What Are the Risks of Buying on Margin?
There are two major components to becoming a successful forex trader.
The first is what we are all aware of: you need to be able to read and understand the forex market.
The second is just as important, and often is the difference between FX traders who consistently make money, and those who don’t: risk management.
So, it’s really important to know what your risks are when trading the forex markets. And one of the things about margin trading is that it magnifies risk. It, of course, also magnifies profit, which is the reason people use it.
In fact, the point of trading on margin is to magnify the effects of things.
What is Margin Trading?
Simply put, margin trading is when you borrow money from your forex broker to invest in the markets.
Usually, you will put up a percentage of the money yourself, and the rest will be supplied by the broker. 1:10 margin means that for every $1 you put up, the broker loans you $9 so that you can enter $10 in trades.
The first risk here is pretty obvious. If the market goes your way, you stand to make ten times as much. But if the market goes against, you will lose ten times as much.
In some cases, you can lose more than you invest, which is why you want to trade with a forex broker that offers protection against your account going negative.
There are quite a few tools that you can use to minimize your losses, such as diversifying your trades, putting a limit on the size of the trade you make, and placing stop-loss orders.
Because trading with margin always implies a calculation of the ratio between how much you are risking compared to how much you have in your account, margin trading accounts are more sophisticated and complicated than your average cash accounts.
Many brokers offer you protections that can become risks of their own.
In order to prevent FX traders from losing more than they are willing to, forex brokers will often stop a trade when it loses the amount that was put up in margin. This protects you from going broke on a bad trade, but it also creates the dreaded margin call.
Originally, the margin call was literally a call: as in, when a forex trader’s leveraged position was losing to the point that the amount of money in his account was getting low, the broker would call him on the phone to ask if he wanted to put more money in to increase the available funds.
Nowadays, most FX brokers will simply terminate a trade that risks blowing out someone’s account when it reaches its margin level. It saves you from a negative balance.
But, that also means that you have significantly less money available in your account for trading. And that will make it a lot harder to recover the money you’ve lost.
The Greed Factor
Generally, forex traders run afoul of risk when they are trying to make trades that are too big, putting too much money into the market at once.
The simplest way of avoiding margin calls is to make smaller trades and use reasonable stop losses. Most experts recommend not taking a trade that requires you to risk more than 3% of your account.
The thing is, when you have a usual cash account, you generally want to put most of it in the market so you can maximize your returns. Money without investing is not doing anything, especially in this low-interest environment.
But, with margin accounts, you have access to significantly more funds to invest. So, not only do you not need to have most of your account in the market at once, but you also don’t want to.
You want to keep your funds in reserve to mitigate risk and be ready for the next market opportunity.
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