Trading in the financial markets has its own language, so getting to grips with the basics is essential before you get going. Some of the most important terminology, and perhaps the most complicated, relates to spreads and margins. Although there are many variables, this is a very simple explanation about how margin works and the potential for profit or loss.
When looking at the difference between the bidding (buying) price and the asking (selling) price, the difference is known as the spread. If the market rate for GBP/USD is 1.34550, the bid/ask price might show as 1.34540 (bid) / 1.34560 (ask). This is a spread of 2.0 pips, meaning you buy at 1 pip below the current market rate and would need the change in your investment to move beyond 2 pips to make a profit on your trade. Many brokers say they offer tight spreads, which is a thinner margin between the market rate and the bid/ask price. As the spread is where brokers make their profit, if there is a very tight spread, chances are they will also take a commision on the final total of your trade. Depending on your trade size it might work better for you to pay a fixed commission (on bigger trades), or choose to pay the spread for smaller trades.
With margin, you are able to place trades for the full value using a smaller amount as a deposit. When you open your brokerage, the amount that you deposit to your trading account will be used as margin on trades. If you had $1,000 in your trading account and the leverage was 10:1, you could open a trade worth $10,000. You don’t have to use all of your margin in one trade. Now you invest in $10,000 worth of stock and the value increases by 10%, a total value of $1,000. Your stock is now worth $11,000. When you close the trade you have made a profit of $1,000 with just $1,000 of margin, a 100% return. However, if you placed the same trade but the stock fell by the same amount of 10%, you would lose $1,000, which is all the margin you invested in the trade.