Investing in overseas markets isn’t restricted to stocks and shares. As you continue to learn offshore trading tips, you will soon discover that you can make money by selling money. Well technically, you’re buying and selling another country’s money. This is called forex trading, or FX trading for short. Forex is short for ‘foreign exchange’ and it can be quite profitable to trade FX online. Before we go any further, we need to be clear about the language.
Words don’t always mean the same in finance as they do in ordinary usage. For example, in plain English, a margin is a space on a page. A margin can also be a statement of profit, meaning the difference between how much money you used to produce something and how much you sold it for. If you spent $20 going to the mall to buy a dress and spent another $20 on the dress itself, then your cost is actually $40. If you then sell the dress for $50, then your profit is $10, and your profit margin is 25%.
In FX trading, the margin has yet another meaning. Sometimes, you want to buy some shares, stocks, or foreign currency, but you don’t have the cash to do it. You then borrow money specifically for the purpose of buying your shares. That borrowed money is margin. It’s a particular kind of loan used to fund forex trading or to buy other financial instruments like stocks and shares. It usually has a fixed interest rate.
Enter the world of financial instruments
In this case, a financial instrument is a piece of paper or a virtual document (like a scanned copy) that shows proof of financial value. It’s a representation of a legally binding agreement, and forex is an example of a financial instrument. So are stocks, shares, bonds, and t-bills. When you use margin to obtain forex, then you’ve essentially created leverage.
In a financial context, leverage is the action of obtaining a margin. It’s the action of borrowing money in order to invest in financial instruments. If you were a grammar nazi, you might say leverage is the ‘verb’ and margin is the ‘noun’. It wouldn’t be entirely accurate though, because leverage could also refer to the amount of money you owe, but that’s a separate discussion.
For the purposes of FX trading, leverage helps you increase your returns. It’s an investment strategy where you increase your profits by using someone else’s money to trade. It allows you to make bigger deals than you could have on your own, and while the proceeds will be the same, you’ll make a bigger profit because you made a smaller investment.
Leverage and profit in action
Let’s look at a practical example. Suppose you’d like to buy a dozen apples. That costs about $12, or maybe $10 if you get a discount for buying so many. Let’s say someone wants to buy your apples for $15. You’ve made a profit of $5, assuming you walked to the store and didn’t spend any money getting there. Profit margins are usually calculated in percentages, so you earned yourself a profit margin of 50%.
Now suppose you were a teenager, and your mum gave you the money for those apples. You didn’t spend any money to buy them, but you sold them for $15, so your profit is now 150%. Now, let’s take this to a higher level and translate it into forex. When you borrow money to trade forex, you’re creating leverage, because you’re increasing your potential for profit.
Using your own money might get you a 50% profit, while borrowing before you buy might help you make 150%. Of course you have to pay back what you borrowed – with interest, so you won’t get to keep the whole 150%, but it’ll definitely be more than 50%.
Understanding leverage ratios
Let’s go back to the profit margins we talked about earlier. When you’re trading forex, you might make a profit of $0.0065 for every dollar. The profit margins are miniscule, so you have to trade in bulk to make decent returns. The more capital you have for funding your trade, the larger your volumes, and the bigger your profit. This means it’s essential to create leverage by borrowing money, so that you can increase your profits.
When you’re trading forex on a day-trading website, you might see banners offering leverage. This leverage is expressed in rations, like 4:1 or 400:1. This means the trading site is offering you a ‘loan’ so that you can buy a larger amount of forex. The ‘1’ here is the amount of money you have deposited onto the platform, and the ‘4’ or ‘400’ is a multiple of your deposit.
So if you deposit $10, and get leverage age 40:1, you will receive a virtual $400 that you can use to trade. It’s a virtual figure, so you can’t withdraw it or cash it in. Also, you don’t pay interest and there’s no deadline for payment, but you can only use your leverage inside the platform. This way, they make their money back in trading fees.
When you take up leverage from your trading platform, it’s called gearing. Some traders do short deals. They buy and sell quickly to benefit from market volatility, so they use high leverage such as 500:1, in order to maximise returns. Long-term traders who intend to sit on their forex and let it mature will go for a smaller leverage of say 5:1. FX traders often select their preferred trading platform based on the amount of leverage the broker offers.
Tread carefully while you trade
Leverage of a trading site is a bit different from ordinary loans. At your bank, the bigger your deposit, the more money you can borrow. On a trading site, having more money means you have a smaller need to borrow, at least in theory, because you can fund your own purchases. So adding cash to your account can actually lower the amount leverage you can gain.
Also, keep in mind that while you don’t have to pay the leverage back, you could still lose all your money on a bad trade, so invest wisely and pace yourself until you know your way around better. And remember, even experts can lose money online.