Understanding The Basic Elements of Forex Trading
The foreign exchange market is finally beginning to garner mainstream attention. The Bank of International Settlements estimates that the average daily volume in the fx market is around $4 trillion, which makes it by far the largest financial marketplace in the world. Surprisingly, however, many novice investors and traders have never even heard of this market.
Until the late 1990’s, the only players allowed to execute trades in the foreign exchange market were investment banks, hedge funds, and very wealthy private investors. Since the minimum contract size was generally $1,000,000, smaller traders were effectively denied entrance into the market.
In the late 90’s, however, this all changed. The advance of the internet and technology led several online forex brokers to open shop and begin catering to smaller investors and traders. This led to the birth of the retail foreign exchange market. In this article, we are going to discuss three key elements to forex trading: Leverage, Margin, and Equity.
The idea of leverage in the fx market has been under intense debate over the last several years. Since the market is decentralized and worldwide, regulation was largely absent from the fx market until recently. In 2010, the National Futures Association instituted some major changes, one of them being a cap on leverage at 50:1. This means that an fx trader in the United States can trade on leverage at a ratio of 50:1. Thus, if a trader has $1,000 in his account, then he is able to leverage that $1,000 into $50,000 and trade much larger positions in EUR USD. Until the National Futures Association passed this regulation, some brokers were offering traders up to 400:1 leverage, which means that with a $1,000 account, traders were able to control a $400,000 position in the market. Note that leverage is a two-edged sword. It will increase both losses and profits.
Margin is the life of a trader. If a trader does not have enough margin, then he cannot open a trade. Furthermore, if a trader has an open position moving against him, he may eventually not have enough money to act as margin, which means his account would suffer a “margin call.”
Margin is the amount of money required to open a leveraged position. For example, if Broker ABC offers 50:1 leverage, and Bob the Forex Trader wants to open a position of $100,000, then Bob has to put up $2,000 of margin. If Bob’s trade begins to move against him to the point where his account equity becomes less than $2,000, Bob will suffer a “margin call,” which basically means that his broker will call for more margin if Bob wants to keep the position open.
Everyone knows that one of the leading causes of business failure is a lack of initial capital, and trading is no different. If a trader opens an account with a few thousand bucks and trades heavily leveraged positions, his chances of success are nominal.
Equity is essential to trading success. The question many new traders have is, how much money do I need to open an account? Well, the answer to that question is different for everyone, and it largely depends on what your goals are. If you simply want to get some trading experience, but still have a full-time job, then a person can open an account with a few thousand bucks. However, if you are trying to generate enough capital gains to sustain a living, then the initial account balance should be much, much higher.
Leverage, Margin, and Account Equity are three essential aspects of fx trading that every trader must be familiar with.