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TRADING BASICS
Courtesy of
DailyFX.com
Simply put, leverage is the ability to trade with borrowed funds. Leverage
is a tool by which traders can determine the level of risk - and thus, the
potential reward -- they assume in the market. The more leverage used, the
more volatile the trader's percentage return of profit or loss can be.
An example of how leverage used in trading is as follows:
Suppose a trader purchases 1 lot of USD/JPY - a trade that involves the
purchase of 100,000 US dollars - at a rate of 116.65. Instead of depositing
100,000 US dollars into his account to place the trade, though, the trader
deposits 10,000 US dollars - and uses the leverage afforded by his trading
firm to purchase the remainder of the position. Mathematically, a trader's
leverage ratio is the value of the position they assume divided by the value
of their account balance. In the example above, the position size is $100,000
and the account balance is $10,000 - thus making leverage 10:1 (100,000/10,000).
Now assume the market moves in favor of the trader, and that the rate jumps
to 117.65 - 100 pips above his rate of entry. The trader now seeks to exit
the trade. At the exchange rate of 117.65, his 100 pips on the USD/JPY are
worth approximately $850. On the total $100,000 investment, this amounts to
a paltry return of just 0.85%. On a $10,000 investment, though, the return
is 8.5% -- an impressive amount for a single trade. Clearly, leverage can
be a critical tool in determining the amount of risk traders assume and the
ultimate return on investment they receive.
Margin: A "Deposit of Good Faith" in Trading
In most FX trading, clients are not required to pay for the entire value
of the lot, or currency, they purchase. Instead, they are only required to
pay for a portion; the rest is given to the trader on the basis of good faith.
The required amount that is needed to put up is referred to as margin. Often,
it is expressed as a percentage; for instance, if a trader purchases 1 lot
of USD/CAD - which is the equivalent of 100,000 US dollars - and his FX trading
firm requires a deposit of $1,000 per lot, the margin requirement as a percentage
is simply 1%, as the dollar value of the margin requirement ($1,000) is 1%
of the total value of the position ($100,000).
Margin Call: Protection When Trading With Leverage
A margin call occurs when the trader's account equity - the total value
of the account, including balance and open positions - falls below his margin
requirement. At this point, dealers may begin to close out positions, thus
ensuring that clients can never lose more than they deposit.
account balance + value of open positions < margin requirement = MARGIN
CALL
One of the obvious dangers of trading on margin is that should the value
of the position fall substantially, the trader's deposit could easily be wiped
out. Meanwhile, the position could continue to fall, thus exposing the trader
to substantial liability. Such scenarios are common in futures and equities
market, and thus margin trading is more dangerous in those arenas.
When clients trade foreign exchange directly with the market maker, the danger
of liability beyond what was deposited does not exist. Instead, FX market
makers can immediately close out a client's position once the account equity
has fallen below the required margin. As a result, FX traders can utilize
margin trading with a much higher degree of safety.
Next: Calculating Profit and Loss
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