Safe Ways to Use Margin
Many traders are wary of using the margin. However, most currency traders will need to use the margin to trade. Remember one lot consists of 100,000 units of a currency in a standard account. In a mini account, one lot of a currency usually consists of 10,000 units of a currency. That’s quite a lot of cash to hold in an account. Most people will trade more than one lot at a time. And most brokerage firms will require traders to have access to margin funds. In short, there is simply no way to avoid using the margin in currency trading.
However, there are ways to use the margin profitably and responsibly. There are a few simple rules to follow that will protect the money and provide access to more profits.
Five Margin Rules
- Remember that margin is customizable.
It can be used to the extent that the trader is comfortable and needs to use this resource. For a risk-averse trader, using perhaps five to ten percent of margin would be comfortable. For a more risk-tolerant trader, forty to fifty percent of margin could be more appropriate. The margin amount for each trade can be customized – using from zero to one hundred percent. Margin is not an all-or-nothing game. So, consider each trade individually and as part of your trading strategy and decide on how much margin is appropriate.
- Never use your entire margin.
No matter how risk tolerant you are, maximizing the available margin is unwise and limits one’s ability to take advantage of other trading opportunities. A wise rule would be to avoid using more than two-thirds (or approximately 60 percent) of one’s margin capacity. This provides room for volatility in one’s trading account without risking the dreaded margin call.
- Examine the risk-reward ratio of each trade.
Margin changes the amount of your potential profit and the amount of your risk (or potential losses) quite dramatically. A rule of thumb is that the risk-reward ratio should be a 1:2 ratio or even higher. Some traders use a minimum of 1:5, but this high ratio will limit your trading ability. Beginning traders may wish to use a 1:3 risk-reward ratio. Do the calculations. Decide if your potential reward is worth the potential risk. If not, look for another trade.
- Be responsible with the extra funds made available by the margin.
Remember that you are using credit. Trading on the margin is like entering a department store at Christmas after having just received a new credit card. Buying opportunities are everywhere, but discipline is essential. The credit card can quickly reach its spending limit. That’s when the perfect gift is found at the perfect price -- but you won’t have any more credit available. If your margin is at the limit, good trading opportunities cannot be taken to their maximum potential. Always exercise discipline.
- Remember that margin trading is risky -- losses are greater.
A trader may want to use margin trading only when a trading opportunity is clear or the risk-reward ratio is very good. Many traders will avoid margin trading whenever the market looks over-extended, unsteady, or unclear in terms of its direction.
Beginning traders should use more than the minimum amount of margin only when the market is showing a strong trending currency pair (as shown by a high ADX number) and strong momentum (as shown by the MACD).
These simple steps can reduce your risk of large losses and could increase your opportunity of higher profits.
