A look at Margine and Leverage in Forex Trading

A Look at Margin and Leverage

Why do so many traders prefer Forex trading over other markets such as stocks and commodities?  Besides the low commissions of currency trading, many traders like currency trading because of the huge amount of leverage that is available.

So what is leverage?  Well, if you ever played on a teeter-totter at the local playground when you were young, you can remember that by just exerting a little bit of pressure you were able to lift a considerable amount of weight quite a distance into the air.  That is because teeter-totters are levers.  Financial leverage is the same. 

By applying just a little bit of money, you can actually make a lot more money, just like the teeter-totter where a little force is applied and a lot of weight is moved.  This is called buying on margin.  And all that means is that you are putting a little money down and getting access to a lot more money to trade with. 

Now when you buy on margin with stocks, you get access to margin on a 1:2 ratio. If you put $10,000 in a stock-trading account, you can purchase $20,000 worth of stock, using $10,000 of borrowed money.  For every percentage point the stock moves up, you will make $200, instead of the $100 you would have made if using your money alone.  The problem is that if the stock goes down, your investment will decrease at double the rate of speed than it normally would have, and if your investment reaches half of the value that you started at, then you now owe $10,000 and the stock you have is worth only $10,000.  The broker will force you to sell the stock that is left in order to pay off your debt in what is known as a margin call.

Margin buying is also available in commodities where you can investment only $1,000 to borrow that same $10,000, or a 1:10 ratio.  Now the leverage that you have is 10 times greater than what it was with stocks.  By using the teeter-totter analogy, that would mean that instead of raising your schoolmate into the air, you can suddenly push down on the teeter-totter and lift a horse into the air.  The leverage is much greater. And herein lies the attractiveness of currency trading (and the danger!). 

With Forex trading, the amount of available leverage is much, much greater than in stocks or commodities.  Generally, you can get a 1:100 margin ratio.  This means that with an investment of $1,000 you can now trade $100,000 worth of currencies.  So if the currency moves up 1%, you would double your investment.  Instead of lifting your friend or a horse into the air, you are now pushing down on the teeter-totter and you are lifting up an elephant. 

In stocks, to double your money on margin, instead of a 1% move, that move would have to be 50%. The more margin you use, the more dangerous it is.  Remember that pushing your friend into the air is a lot safer than pushing an elephant up the teeter totter. What that means is that if you are leveraged 100 times with a currency trade and the currency moves down 1%, you just wiped out your entire investment. 

Like the little kid on the teeter-totter, the elephant doesn’t have to move much to send the kid flying into the air.  But if you want to make a lot of money quickly, there is really no more convenient way to do it, than by maximizing your leverage.  Just remember there is no more dangerous way to do it either.

© GetForexHelp.com

Technorati Tags: commodities, forex trading, leverage, margine, stocks