Thanks to margin, today online forex trading is available to any investor.
Margin allows a trader to control 100 - 500 times more the amount of money actually deposited. When there is a chance of profit, there is also a possibility of loss.
By borrowing sums that a trader doesn’t actually possess, is it possible to lose more money than invested? Is there a possibility of negative balance? Can you end up owing a large sum of money to the forex broker?
How is Effective leverage calculated?
And if so, how can you protect yourself from it?
Do You Borrow Money from Forex Broker?
First of all, let’s understand what margin actually is.
In forex currencies are sold in lots or in other words - $100,000. When trading with margin account, the term “leverage” joins the game. Leverage displays the money “borrowed” from a broker.
Leverage varies from 1:50 to 1:500, depending on a broker and the size of a trading position. For example, you have opened a 1% margin account and deposited $1,000.
Leverage 1:100 allows you to control $100,000 instead of just $1,000.
What is The Risk?
Now, what is the risk of margin trading?
Use the Least Amount or None at All
Once you use margin account, your get a significant financial boost and a greater chance of potential profit. However, it is very easy to completely wipe all of your account out within seconds.
When you have 1% margin account and there is a slight currency move, even a single penny will cost you $1,000!
With that being said, margin accounts give a forex trader a chance to dramatically increase the profits, and at the same time there is an increased risk involved in every trading decision. It is possible to lose more money than invested.
And here is another frequently ignored risk - forex brokers can close the trading position when the price reaches the point where losses are almost equal to the value of your margin account.
In this situation, you can not only lose the entire account balance but also lose any change to make a profit in case the price suddenly changes the direction and moves up again.
Can You Lose More Money than You Have Deposited?
The basic rule of thumb is never trade the amount you cannot afford to lose. The last thing you need is to get the savings, the car and your house confiscated!
To avoid any trouble related to margin trading, always read your forex broker terms and conditions before agreeing to them.
Some brokers do not hold you responsible for a negative balance caused by trading activity where loss is greater than the deposited amount, meaning that the worst case scenario is when you lose the entire deposited sum.
However, there are forex brokers that hold you responsible for the negative balance and will require you to deposit more money to cover it.
In case you agree to such contract, you can not only lose all of the money in your account, but also end up owning money much greater than your initial deposit.
Review Ways to Protect Yourself
Luckily for all of us, most forex brokers offer a negative balance protection called Margin Call, and will automatically close a trade before the loss becomes more than the initial deposited balance.
What is leverage?
Stop Loss Order
Stop Loss Order will automatically close your trading position the moment the price reaches the point you have set. This is a great way to limit the potential loss and still stay in the game to make profits.
3. Understand Leverage
Just because your forex broker gives 500:1 leverage option, doesn’t mean you should go for it.
Leverage not only increases your potential losses, but also increases the transaction costs as a % to your trading account. If you are a beginner in forex trading, while gaining an experience, use small leverage (like 50:1).
Understanding Forex Leverage, Margin Requirements & Trade Size
This will increase your potential profits and protect you from completely wiping your account clean.