Two very important concepts of forex money management are leverage and margin. Leverage allows forex traders to invest much more into currency trading than is available in their trading accounts. Thus, forex traders can operate larger funds. Margin is the real funds that are required to be held in the trading account as a collateral to cover any possible losses.
Forex Money Management: Leverage
Profits and losses in the forex market tend to be higher than what you would experience in the stock market even though the actual price of currencies may not fluctuate wildly. Most brokers allow a 100:1 leverage. This means you can buy or sell €100,000 worth of currencies, even though you have only €1,000 in your trading account. Some brokers offer leverage as high as 400:1.
Leverage can also work against you in forex trading. For example, if a currency moves against your expectations, the leverage would multiply your loss by the same factor as it would multiply the gain. Many people starting forex trading do not completely understand the concepts of leverage and margin. Leverage appears to be an amazing service provided by brokers. However, one must remember that even a 1% fluctuation of currency prices could wipe out your entire capital, depending on the amount of leverage offered by the forex broker. Using a smaller leverage could help you prevent losing too much too fast. So, you need to find the perfect balance.
Forex Money Management: Margin
In the example stated above, when you buy €100,000 worth of currencies, you are in fact borrowing €99,000 for your purchases. The €1,000 that is used to cover your losses is the margin.
|Leverage||Margin Required||Amount Traded||Required Margin|
A trader may choose the highest leverage (200:1), with the margin being only 0.5%. However, sound money management principles say that the trader should never trade huge lots. This would prevent leverage from hurting the trader.
Therefore, it is essential to understand how much leverage your forex broker offers and what the margin requirements are. If you are new to trading, you should compare the leverage and margin specifications of different brokers.
by Kitz S