What is Margin and how does it apply to the Forex Market?

A margin deposit in the Forex market, unlike the equity markets, is not a down payment on a purchase. Rather, the margin is a performance bond, or good faith deposit, to safeguard against the possibility of trading losses.

The amount of borrowing power in your margin account is referred to as leverage. Leverage is usually expressed as a ratio. For example, a leverage of 50:1 allows the investor to control assets worth 50 times their deposit. In the Forex market, with a 2% margin account the investor can control standard lots of $100,000.00 with a $2,000.00 deposit.

Forex currency pairs are quoted out to four decimal places. For example, as opposed to $1.42 a Forex quote is displayed as $1.4283. The smallest unit in a Forex quote is called a pip or point and with a $100,000.00 lot, one pip in USD is worth $10.00.

Using an example of 100:1 leverage on a $100,000.00 currency lot: a 5-pip price change ($50.00) on a $1,000.00 investment is equal to 5%. Without margin, the same price change on an investment of $100,000.00 is equal to .05%. Clearly, the benefit of margin is the potential for increased profit. However, along with the potential to increase profits there is also the potential to increase losses. Proper risk control is essential to achieving long term investment success.

Forex trading has several methods to limit loss. One of the main tools is the stop loss order. Please note, the placing of certain orders (stop-loss and stop-limit) may not be effective under certain market conditions. Stop loss orders automatically close a position if the value of the currency crosses a pre-determined point. Dynamic stop losses are also used to protect profits.