In this video you'll learn how margin works when trading currencies, the benefits and
risks of trading on margin, and how it can affect your trades.
Let's start by looking at the units currencies are traded in.
Most currencies are traded in lots.
The lot sizes vary depending on the amount of money an investor wants to devote to a
position.
At TD Ameritrade, you have the ability to trade in standard lots, mini lots, and micro
lots.
A standard lot represents 100,000 units of a currency, mini lots represent 10,000 units,
and micro lots represent 1,000 units.
When trading currencies, you're dealing with pips.
A pip is a percentage of a point that actually extends four decimal places.
This means you're commonly dealing with 100ths of a penny.
However, when trading Yen (JPY), a pip only extends to the second decimal, 0.01.
Depending on the currency pair, A 100th of a penny with 100,000 units means each pip
is worth about $10.
For example, let's say the exchange rate for euros to U.S. dollars is a ratio of 1.4.
In this case, 100,000 units mean that 100,000 euros is the same as $140,000 U.S. dollars.
Investing $140,000 may be difficult for some traders, which is where margin comes in.
When purchasing a lot in the forex market, you're actually placing a good faith deposit
known as a performance bond but commonly called margin.
If you're familiar with margin in stocks, margin in the forex market is not much different.
When trading stock, the margin requirement is the amount of capital needed to enter into
a position.
The same is true for currencies.
Margin in the forex market is simply the amount of capital you need to open a position in
a currency pair.
Trading on margin creates leverage which can result in significant gains as well as significant
losses.
Forex can be split into two different categories: major pairs and minor pairs.
Major pairs, such as the US dollar, euro, and yen are more commonly traded and the margin
requirement can be as low as 2%, which results in 50 to 1 leverage.
So, for every dollar you have on margin, you control about $50 in a trade.
As we stated earlier, this 50 to 1 leverage applies to certain major pairs, but minor
pairs like the Mexican peso, Singapore dollar and Hong Kong dollar are commonly 20 to 1.
These ratios can change, so talk with the Forex Trade Desk to be sure you understand
the leverage you're dealing with.
Let's go back to our example where 100,000 euros equaled $140,000.
How much would you need on margin to trade this pair?
Well, a 2% margin requirement is simply 2% of the total unit value.
Therefore, your margin requirement would be $2,800.
On pairs where the U.S. dollar is not included, the total unit amount will have to be converted
to U.S. dollars.
If you think about it, $2,800 isn't a lot of money to control $140,000.
This means it wouldn't take much for the pair to move against you and eat up your initial
margin.
Let's look at an example of this type of leverage.
Remember that when trading standard lots of 100,000 units each pip movement equals about
$10.
Therefore, a pair that increases 90 pips could result in a $900 profit.
Of course, the opposite is also true; a decrease of 90 pips could result in a $900 loss.
The leverage gained through margin is one of the biggest reasons traders trade the forex
market.
However, this is also why smaller lots may be preferable.
Trading mini- or micro-lots might be more suitable for your trading goals and risk tolerance.
Mini-lots represent 10,000 units with a pip value of around $1 and a micro-lots represent
only 1,000 units with each pip worth about 10 cents.
While these forex trades can be rewarding, there is also some risk because of the leverage.
. So you should always have a well-defined plan when you're dealing with margin that
determines a clear exit.
This way, if a trade doesn't work the way you expect, you can limit the losses.