Thanks to modern technology, retail traders have more opportunities than ever to participate in foreign exchange markets. Although this activity has traditionally been dominated by investment banks and hedge funds, the retail market is up to about 5%, which translates to around $254 billion.
The attraction of leverage and margin trading is not hard to understand. Simply put, investors have an opportunity to maximize return for a much smaller outlay of cash, designated as the initial margin requirement. This means that a larger position can be maintained when compared to trading without leverage.
Just to recap, margin trading is a practice where the cost of the position is primarily paid by a broker or exchange, with the retail customer bearing initial responsibility just for the margin. This is roughly analogous to the down payment on a home purchase, where the mortgage is the leverage amount.
When a trader trades with borrowed money, they can increase their market exposure beyond the size of their trading account. This is the risk of using margin products. Rewards can be significant, but losses can be catastrophic.
To get started in margin trading it is necessary to have a separate account that is distinguished from the cash account used in traditional trading. Take the example of short selling. This can only be done with borrowed financial instruments.
A Contract for Difference (CFD) is a derivative contract where the buyer does not own the underlying asset. The CFD looks to the difference between the price of the underlying asset, and the trader makes profit (or loss) based on the change in that price. An example would include a trader speculating that the value of the US dollar would rise against the Japanese Yen. the CFD would be a USD/JPY currency pair and the analyst could make profit based on that speculation. CFDs can track any asset class, but the risk is significant as profit and loss can be magnified.
Spread betting is another derivative trading product that utilizes margin. With spread betting, a trader buys at the offer price if he thinks p[rice is going to rise and sells at the bid price if he thinks price is going to fall. Profit is made on the difference between opening and closing prices. The spread refers to the difference between the buying and selling price of the instrument.
Margin trading can seem mysterious, but the main concern is to know the risk. Once that is understood, it is more accessible now than ever before.