Take this scenario, you want to buy a vehicle with no enough money to complete the sale. One of the option may be approaching a bank and asking for a loan. Since account balance is not enough, a deposit for the vehicle will be paid and the bank will top up the rest to buy the vehicle. The vehicle will be collateral damage for the loan until it is fully repaid.
How does this relate to margin trading? When you want to open a trade, the broker will offer you leverage and with this you will be enhanced to trade with higher amount than what you hold in your account. This enables the trade to be amplified for higher gains, also higher losses may be realized.
Main features of margin trading
Below we are going to go through different features that make up margin trading and examples of margin trading.
1. Leverage
Basically leverage is a multiplier factor that enables a trader to open a trade with a higher amount invested. a leverage of 1: 500, what that means for every $1 invested by the trader, the broker will provide $500 to make it possible to open the trade. Hence if the trader were to open a trade with $4 the trade to be opened will be $2000 (4$*500 as per leverage). This enables the trader open a trade with little amount on total portfolio and make more profit when prediction of the made on asset was correct without risking huge amount of the total portfolio. Also the opposite is also true when the trade goes the opposite of the what the trade predicted.
2. Pip Value
This is the smallest price change of the asset or financial instrument. One pip is represented by the fourth digit after the comma or the dot of the asset to trade. Incase of yen the pip value will be the second value after the comma or dot.
3. Quantity
This is the total amount a trader wants to open a trade. Lots are the basic measurement of quantity. Lots are of different value ranging from:
standard = 1 = 100,000 base currency
mini lot = 0.1 = 10,000 base currency
micro lot = 0.01 = 1,000 base currency
nano lot = 0.001 = 100 base currency
4. Margin
Margin is the amount of funds that will be required to open a trade, this money will come from trader's account. Once the trade is opened, margin will be withheld / froze by the broker until the trade is closed.
To calculate the margin the following formula is used:
Margin = lost size * contract size / leverage
For the above formula contract size is equal to 1 lot (standard lot)
Example
Case of
Forex trading on EUR/USD With leverage of 1:500 (Base currency in USD)
1. for 1 lot The pip value will be $10.00 and the margin will be $216.46.
2. 0.007 lot, the pip value will be $.07 and the margin will be $1.52.
3. 0.023 lot, the pip value will be $.23 and the margin will be $4.98.
4. 0.007 lot, the pip value will be $.07 and the margin will be $1.52.
5. 8 lot, the pip value will be $80 and the margin will be $1,731.67.
6. 43 lot, the pip value will be $430 and the margin will be $9,307.74.
7. 103 lot, the pip value will be $1,030 and the margin will be $22,295.28.
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