Margin trading refers to trading with
leverage, therefore opening up the possibility of a higher ROI. Leverage is a
key forex
trading term and is explained in the next section. The best part about
margin trading is that while there is an opportunity to walk away with a
considerable profit, the risk is reduced due to the initial investment role.
Simply put, margin trading does not involve the actual purchase of financial
instruments, like stocks. Instead, it is about investing a certain amount of money
through a broker expecting that you will earn the same profit as from actually
buying the financial instrument, without investing a huge chunk of capital.
All trading transactions are traded
with a margin at most of the brokerages. Therefore, for a small amount of
investment, investors obtain exposure to a larger trading position, hence
generating a more significant ROI.
Leverage & margin
Leverage (aka gearing) is a key term in forex
trading. It means that you invest a small sum of money as collateral to the
forex broker, to earn profits implied for higher investment. Let's say a forex
broker tells you that if you want to trade a standard lot of USD/EUR currency
pair (equivalent to 100,000 USD), the leverage is 400:1. It means that you are
expected to invest 1/400th (or 0.0025) times the actual trade volume, which is
a standard lot equivalent to 100,000 USD. If you do the math, the amount of
money you should be investing in is 250 USD. This amount is known as
"margin." If you wanted to calculate your leverage in margin trading,
all you need to do is use the simple formula below:
How exactly does it work?
The best way to understand a concept
is to work through the examples.
Let's begin with the conventional
trading approach. We'll assume that apple shares are trading at USD 90.00 per
share. Now, let's take again that you expect the stock price to rise to USD
100.00 per share soon. Therefore, you invest your actual money in buying 200
shares of apple. So, how much money did you invest? The answer is USD 18,000.00
(USD 90.00 per share multiplied by 200 shares). When the stock price touches
USD 100.00, your stocks' great value will become USD 20,000.00 (USD 100.00 per
share multiplied by 200 shares). This means you earned a profit of USD 2,000.00
at the expense of investing USD 18,000.00. Your profit percentage, in this
case, is 11.11%.
Now, let's take a look at margin
trading. When you are trading with a margin with brokers, you
don't actually buy the stocks. Instead, imagine that the broker will approach
you with an offer to invest in 200 shares of apple trading at USD 90.00 per
share with leverage of 10:1. What exactly does this mean? It means that you
only need to invest 1/10th of the grand trade size of USD 18,000. Therefore,
your margin is USD 1,800.00. If the apple stocks' price does touch USD 100 per
share, then your profit will still be USD 2,000.00, as shown below:
Essentially, you end up with a profit
margin of USD 2,000.00 by just investing USD 1,800.00. The profit percentage in
this example is 111.11%. Compare this with the profit margin in the last
scenario, and you will see how margin trading can help you obtain a higher profit
percentage at a significantly lower risk.
