Hey all, I’m reading Currency Trading for Dummies. I got to this part:
Most individual traders trade currencies via the Internet through a brokerage firm. Online currency trading is typically done on a margin basis, which allows individual traders to trade in larger amounts by leveraging the amount of margin on deposit.
What does the author mean by margin exactly?
You want to trade forex.
You go to your friendly forex broker and say,
“I want to risk my tiny account (say $1,000), speculating on a huge amount (say $30,000) of this currency pair.”
Your friendly forex broker says,
“Fine. But, you could lose your whole account — which is okay with us, but we don’t want you losing any of [B]our[/B] money. So, we’re going to escrow 2% of that $30,000 position you want to take, and we’re going to hold it as a cushion to protect us. We call this [B]margin.[/B] That way, you can lose all of your account except that last 2% ($600 in this case). If your account gets down to $600, while this position is open, we will close your position automatically. Then, you’ll get your $600 back.”
That 2% ($600 in the example above) is margin. It’s there to protect your broker, not you.
Margin is the inverse of maximum allowable leverage. If your broker allows you to use up to 50:1 leverage (which is the maximum allowed by law in the U.S.), he will require 2% margin on each position you enter.
Required margin = 1 ÷ maximum allowable leverage.
Maximum allowable leverage = 1 ÷ required margin.
Gotcha, thanks.
Actually. You have thhose two simple equations. Aren’t they contradicting each other?
No, they aren’t.
Required margin = 1 ÷ maximum allowable leverage.
Required margin = 1 ÷ 50 = 0.02 = 2%
Maximum allowable leverage = 1 ÷ required margin.
Maximum allowable leverage = 1 ÷ 0.02 = 50 (that is, 50:1 leverage)
Got it. Thanks again.