The Secret Behind the Big Gains in the FX Markets

Joined : 23 Dec 2007 Posts : 241 Location : Nigeria

Today's commentary is by Sean Hyman, our Currency Director and editor of The Money Trader.

Good Day Currency Traders!

Just like in stocks, you can shoot for the higher returns in the currency markets by leveraging your currency trades. That's how the professionals manage to make the double or triple-digit gains.

But you have to know how to use leverage in the currency markets.

So how does leveraging your currency trades differ from leveraging your stock trades?

For starters, you don't have to pay margin interest to hold a leveraged position like you do in stocks. You're allowed to control a currency pair as long as you put down a "good faith deposit."

So if you're trading currencies with a mini-account, you'd generally put down US$50 deposit to control each mini-lot. I say generally because different brokers allow different amounts. Some will have you put down as little as US$25. And some want you to put down as much as US$200 or so to control the exact same position.

The Ins and Outs of Holding a Leveraged Position
Let's suppose I had US$5,000 dollars in my currency trading account. If I open up one mini-lot, then my broker sets aside US$50 out of my account as a good faith deposit. That gives me the "right" to control that position. It's much like your banker letting you control your house even though you haven't paid for all of it yet.

It works in a similar fashion in forex trading. My US$50 controls one mini-lot (or 10,000 units of currency). Then when I close out that lot, the US$50 is freed up and back in my "usable margin."

Your usable margin is what you have left in your account once your broker takes the "good faith deposits" out of the equation. Then if the trade goes against you, your usable margin starts going down. If your usable margin goes to zero, then you experience a margin call. That means your firm closes out your position from their side.

Some brokerage firms work to ensure that your trading account doesn't post negative balance. When you're choosing a broker, make sure you ask if your potential broker provides this service. Otherwise, you could end up losing a bit more than what you had in your account.

However, at some firms if you've got US$5,000 in your account, then that's the most you can lose.

That's incredible if you compare it to trading margined stocks or commodities. In stocks, you can lose far more than you put in if you're on margin. The same goes for trading commodities. Yet you get higher leverage in forex than you do in either stocks or commodities. So be sure to ask your broker what their policy is on how they handle margin calls and debit balances.

Putting in a Little to Control a Lot
To sum up: Leverage means you put down a little to control a lot essentially. So when you're putting down US$50 to control one lot, you're controlling 10,000 units of currency. So in this instance, you've got 200:1 leverage because your initial good faith deposit is 200 times smaller than the amount you're investing.

Leverage is a double-edged sword. It magnifies both gains and losses. That means leverage allows you to either turn a small investment into large returns, or lose a lot faster.

I hope you've had a Merry Christmas. Have a happy New Year!
Sean Hyman, Currency Director