Forex: Trading on a Margin
Part of the popularity of Forex is that, in practice, even if you only have $1,000 in initial capital, you can buy and sell a currency worth up to $100,000.
In Forex parlance, this is called trading on a margin. Investors might think of margin trading as a baitfish to get them into that forex trading habit, but there are certainly merits to this practice.
Like other financial instruments like Treasury bills and the stock market, foreign exchange has markets where there are high minimum amounts to buy and sell currencies. If an investor can only afford to risk that much money in forex, trading on a margin gives investors the opportunity to partake of high returns that has made forex a US$1.5 trillion per day industry.
Margins are what make forex so appealing, aside, of course, from the high liquidity of the markets (money is traded over night through online trading centers that are based in Sydney, Tokyo, London and New York.
Forex markets typically require relatively small margin deposits - for as little as one percent of the trade amount. The high leverage (also called 'gearing' in actual forex) allows investors to take advantage of the small fluctuations in exchange rates. The average leverage ratio of forex is 100:1.
Do the math to see how much you can profit by buying a currency at $1.20 for one unit and then selling at $1.23.
Leveraging makes it possible for investors to profit really quickly, but they also run the risk of large losses, and of their money being completely gone, when they maximize the leverage.
Trading centers require investors to put up a collateral to insure against any losses. In actual forex practice, the collateral is known as the margin (the initial investment) or minimum security.
The margin is also used to cover administration costs.
There are actually five vehicles in forex: futures, options, contracts for difference, spread betting, and spot market.
Leveraging is an especially common practice in forex trading in the spot market, precisely because the spot market generates the highest volume of trading among the forex vehicles.
A spot transaction has the shortest timeframe for sealed deals, typically two days, and involves exchanging cash rather than fulfilling a contract. A spot transaction is actually a direct exchange between two currencies.
With short turnaround times and with its promise of cash liquidity, it is no wonder that leveraging is a risk investors often take.