The traditional players – banks, governments, multinational companies – dominate the forex market activity. However, retail traders are increasingly moving into the market. How can smaller-scale retail traders participate in the same market as banks? The key is margin trading. Margin is a powerful tool, but there is also risk associated with it. An understanding of how margin works is crucial for any forex trader.
What is margin trading?
Margin trading accounts allow forex traders to control a large sum of currency with very little capital. Questrade provides forex clients with initial margin of 0.5% in mini accounts, and 1% in standard accounts. For example, a trader with a standard account can control USD $500,000 with only USD $5,000.
Example:
A trader has USD $10,000 cash in a forex trading account. He buys 500,000 euros against the US dollar (EUR/USD) at 1.3325. The initial margin requirement is 1% or USD $6,662.50 (500,000 x 1.3325 x 0.01). Every pip movement in the EUR/USD is now worth USD $50. The maintenance margin requirement is $3,331.25, assuming account net equity is below USD $50,000. See Forex Margin for details.
Scenario A: market rises to 1.3512
The trader has a gain of 187 pips or $9,350 (187 x 50). This is the equivalent to 140% return on the margin deposit, or a 93% return on total equity.
Scenario B: market falls to 1.3191
The trader has a loss of 134 pips or $6,700 (133 x 50). The trader now has equity of $3,300. This is below the maintenance margin requirement of $3,331.25 and the account will be liquidated. The trader has a 50% loss on his initial margin deposit or a 67% loss in account equity.
What is the risk?
There is always risk associated with margin trading. Traders experience profit or loss on the position size that they control, not on the small cash outlay that they make (initial margin). Risk can be compounded if traders over-leverage their trading accounts, or use up almost all of their buying power. Trading in such a manner can quickly lead to significant percentage losses and even account liquidation.
Managing risk
Managing risk starts with having a game plan. A number of factors, such as the high degree of speculation, can make market conditions very volatile. To offset that volatility, successful forex traders pre-determine each trade's parameters, setting such key points as how much he or she is willing to lose on a particular trade or the maximum percentage of an account that may be leveraged at one time. These conditions can be set within the trading platform. The most commonly used tools are:
- Stop loss orders
- Stops attached to positions
- Stops as part of contingent orders
- Trailing stops
- Risk/reward ratio using if/then or one cancels other orders
There are a few simple ways to familiarize yourself with the risks of the forex market and the tools provided by Questrade. First, practice with a demo account. This will expose you to the market and the risk management tools, giving you the opportunity to become comfortable with the environment. Second, take instructional courses offered by our third-party training providers.
We also encourage you to carefully read Questrade's Forex Risk Disclosure Statement.
