Forex Trading - Lots, Margin Accounts, and Leverage
Before the advent of the Internet, FOREX trading was the exclusive domain of the "big players." Only banks and other large financial institutions with millions of dollars to "play" with could qualify. But now, the Internet has made it available to everyday people and we can trade with very little money through online FOREX trading firms-brokers and dealers. If you have a computer, a high-speed Internet connection, and a little money to "play" with, you can become a FOREX trader, especially if you know how to use leverage to your advantage. That is what this article is about. NOTE: I also, briefly, covered "lots" and "margin accounts" in How The Foreign Exchange Market (Forex) Works. If you have not read that article, it would be good to do so now. (It is in 3 parts so be sure to start with Part 1.) Now, let's get into Lots, Margin Accounts, and Leverage more fully to show you why trading in lots is so important and how trading in lots with leverage makes it possible to earn high profits. Remember these four things: Currencies are measured in PIPS, which is the smallest increment of a currency exchange rate. NOTE: If you don't know what PIPS are, you may want to read my article What Are Pips? before continuing. Spot FOREX is traded in lots. The size of a standard lot is US$100,000 and the size of a mini lot is US$10,000. Margin accounts give traders tremendous leverage. To take advantage of the small monetary increments represented by pips, a trader must trade large amounts of a currency in order to realize any significant profit potential. This is where leverage comes in. Remember, in FOREX, traders can trade large amounts of currency with relatively small amounts of capital by using the leverage they have with their margin accounts. IMPORTANT NOTE: It is not necessary to do the following calculations yourself in order to trade FOREX because your broker will do them for you, automatically. This section is here for educational purposes in case you simply want to understand the math behind it all. It is important to know that your broker will show you the pip value for the currency you are trading in real time. First, calculate pip values: For these examples, we will use a $100,000 lot size. USD/JPY at an exchange rate of 119.90 (.01 / 119.80) x $100,000 = $8.34 per pip) USD/CHF at an exchange rate of 1.4555 (.0001 / 1.4555) x $100,000 = $6.87 per pip) When the US Dollar is not quoted first, the formula is different. EUR/USD at an exchange rate of 1.1930 (.0001 / 1.1930) X EUR 100,000 = EUR 8.38 x 1.1930 = $9.99734 rounded up will be $10 per pip) GBP/USD at an exchange rate or 1.8040 (.0001 / 1.8040) x GBP 100,000 = 5.54 x 1.8040 = 9.99416 rounded up will be $10 per pip.) Calculating profit and loss In this example, you will buy US dollars and Sell Swiss Francs The rate you are quoted is USD/CHF 1.4525 / 1.4530 (The first part of the quote is the bid price and the second part is the ask price.) Because you are buying US you will buy at the ask rate of 1.4530, which is the rate at which traders are prepared to sell. You buy 1 lot of $100,000 at 1.4530. Later, the price appreciates to 1.4550 and you decide to close your trade. The new quote for USD/CHF is 1.4550 / 14555. You initially bought the pair to enter the trade, but now since you are closing the trade you must sell the pair at the bid price of 1.4550 (The price at which traders are prepared to buy.) Since the difference between 1.4530 and 1.4550 is .0020 (20 pips), using our formula from before, we now have (.0001/1.4550) x $100,000 = $6.87 per pip x 20 pips = $137.40. You have earned a profit of US$137.40. NOTE: When you enter or exit a trade, you are subject to the spread (the difference between the two quotes) in the bid/ask quote. This is how brokers are paid for their services. You buy a currency at the ask price and you sell a currency at the bid price. Further, when you buy a currency, you pay the spread as you enter the trade-not as you exit. Conversely, when you sell a currency you don't pay the spread when you enter but only when you exit. More about leverage and margin accounts You get leverage when you open a margin account. The topic of margin accounts is sometimes controversial because using too much margin can be very risky. However, it all depends on the individual trader. The important thing is to make sure you understand your broker's margin account policies so you can correctly assess the risk. Leverage gives small investors and large investors, alike, the ability to trade large amounts of money with small amounts of money. For example, if you choose to trade with a 1% margin account, you will be able to trade $100,000 in currencies with a $1,000 deposit. This is how leverage works in the FOREX market. As you will learn later when you look at different brokers, the amount of leverage available to you depends on the policies of the brokers. Brokers require a minimum account size, which is also known as account margin or initial margin. They also specify how much is required per position (lot) traded. The minimum security (margin) for each lot may also vary from broker to broker. Margin Call If the money in your account falls below margin requirements ( also called "usable margin"), your broker will close some or all of your open positions. This prevents your account from falling into a negative balance. It is a safety mechanism. Example 1 You open a FOREX account with $2,000. You then initiate a 1 lot trade of the EUR/USD pair, which has a margin requirement of $1000. "Usable Margin" is the money available to open new positions or sustain trading losses. In this case, since you started with $2,000, your usable margin is $2,000. But when you opened the 1 lot trade with a margin requirement of $1,000, your usable margin changed; It is now $1,000 ($2,000 - $1,000 = $1,000). In this example, if your losses exceed your usable margin of $1,000 you will get a margin call. Example 2 You open a FOREX account with $10,000. You then initiate a 1 lot trade of the EUR/USD pair, which (again) has a margin requirement of $1000. Remember, usable margin is the money you have available to open new positions or sustain trading losses. So prior to opening the 1 lot trade, you had a usable margin of $10,000. After you open the trade, you have a $9,000 usable margin and $1,000 of used margin. In this case, you will not get a margin call unless your losses exceed your usable margin of $9,000. If because of trading losses, the equity (the value of your account) falls below your usable margin, you will either have to deposit more money or your broker will close your position to limit both your and his. Therefore, you can never lose more than you deposit. Again, it is a safety mechanism. IMPORTANT: Be sure you know the difference between usable margin and used margin. Also, learn what your broker's margin account policies are before you open one. NOTE: Most brokers require a higher margin during the weekends. For example, a 1% margin during the week may rise to a 2% or more margin if you hold the position over the weekend. Check your broker's policy on this. ANOTHER NOTE: While some brokers define leveraging in terms of a "leverage ratio", others define it as a "margin percentage." For clarity, the relationship between the two terms is: Leverage = 100 / Margin Percent Margin Percent = 100 / Leverage (To keep it simple: Leverage is conventionally displayed as a ratio, such as 100:1 or 200:1.) Now, you know how you can use relatively small amounts of capital to buy and sell relatively large amounts of currencies. It's all about leverage! Find a money-making Forex strategy at [http://bestforexstrategies.com]. While you're there, be sure to checkout the other free Forex articles, forex strategies, software, signals and books. Whether you are an experienced Forex trader, a novice, or you don't have a clue, Best Forex Strategies is designed to help you make money in Forex trading. Article Source: http://EzineArticles.com/2721274
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