Trading currencies on margin lets you increase your buying power. Here's a simplified example: If you have $2,000 cash in a margin account that allows 100:1 leverage, you could purchase up to $200,000 worth of currency because you only have to post 1% of the purchase price as collateral. Another way of saying this is that you have $200,000 in buying power.
Benefits of Margin
With more buying power, you can increase your total return on investment with less cash outlay. To be sure, trading on margin magnifies your profits AND your losses.
Here is a hypothetical example that demonstrates the upside of trading on margin:
With a US$5,000 balance in your margin account, you decide that the US Dollar (USD) is undervalued against the Swiss Franc (CHF).
To execute this strategy, you must buy Dollars (simultaneously selling Francs), and then wait for the exchange rate to rise.
The current bid/ask price for USD/CHF is 1.6322/1.6327 (meaning you can buy $1 US for 1.6327 Swiss Francs or sell $1 US for 1.6322)
Your available leverage is 100:1 or 1%. You execute the trade, buying a one lot: buying 100,000 US dollars and selling 163,270 Swiss Francs.
At 100:1 leverage, your initial margin deposit for this trade is $1,000. Your account balance is now $4000.
As you expected, USD/CHF rises to 1.6435/40. You can now sell $1 US for 1.6435 Francs or buy $1 US for 1.6440 Francs. Since you're long dollars (and are short francs), you must now sell dollars and buy back the francs to realize any profit.
You close out the position, selling one lot (selling 100,000 US dollar and receiving 164,350 CHF) Since you originally sold (paid) 163,270 CHF, your profit is 1080 CHF.
To calculate your P&L in terms of US dollars, simply divide 1080 by the current USD/CHF rate of 1.6435. Your profit on this trade is $657.13
* Initial Investment: $1000
* Profit: $657.13
* Return on investment: 65.7%
If you had executed this trade without using leverage, your return on investment would be less than 1%.
Managing a Margin Account
Trading on margin can be a profitable investment strategy, but it's important that you take the time to understand the risks.
* You should make sure you fully understand how your margin account works. Be sure to read the margin agreement between you and your clearing firm. Talk to your account representative if you have any questions.
* The positions in your account could be partially or totally liquidated should the available margin in your account fall below a predetermined threshold.
* You may not receive a margin call before your positions are liquidated.
You should monitor your margin balance on a regular basis and utilize stop-loss orders on every open position to limit downside risk.