Understanding Margin Trading – Implications and Complications

One of the features which attract investors to spot forex trading or retail spot forex is the fact that it is done by way of a margin trading system that allows investors to maximize the returns because of their investments. For example, beneath the margin trading system, a trader with just a $5,000 deposited in his account can buy or sell around $500,000 worth of currency contracts. Why don’t we examine how that is possible.
According to “Wikipedia”, ‘ a margin is a collateral that the holder of a position in securities, options, or futures contracts must deposit to cover the credit threat of his counter-party (frequently his broker).
In online spot currency trading, the buying and selling of currencies are done in tranches or by plenty of $100,000 each. Whenever a trader opens a merchant account with a broker, his initial margin deposit serves as a collateral to cover future losses that your trader may incur throughout his trading activities. In exchange for the margin deposit, the broker extends a credit line to the trader equivalent to 100 times his margin deposit (200x for other brokers). The trader can then trade around 5 lots or $500,000 worth of currencies. Profits and losses are computed in line with the amount of lots the trader has bought or sold.
To illustrate this, view the example below:
Trader A opens a merchant account with Broker B with a $5,000 deposit. He buys 1 large amount of USD against yen at the existing exchange rate of 93.00Y to $1.
1) He commits $1,000 of his margin deposit to the trade as collateral and borrows 9,300,000 Yen from the broker to get 100,000 USD.
2) Assuming that rate of exchange went up to 94.50Y to $1, the trader’s $100,000 (1 lot) will now be worth $100,000X94.50 = 9,450,000 Yen.
3) If the trader decides to sell his dollars as of this level, he will realize a profit of 150,000 Yen computed the following:
Sold 1 lot USD against Yen $100,000 x 94.50 —-9,450,000 Yen
Bought 1 lot USD $100,000 x 93.00—————9,300,000 Yen
Net Profit ————————————-150,000 Yen
At the current exchange rate this is equal to:
150,000 Yen/94.50 ———————–$1,587.30
But hold up for one minute there. You need to realize that this could be another way around had the trader not bought but sold the dollar instead! The $1,587.30 is a loss! And it would have wiped out the original $1,000 margin committed to the trade and would have started eating up in to the rest of the trader’s margin deposit.
Now, this is what every trader must understand clearly (the complications). Because the prices start to go against you, the value of the contracts you’re holding will depreciate in value much like our computation above…and more important, your margin deposit will also depreciate in equivalent value. The general practice being accompanied by most online brokers is to set a cut point (called officially as margin call point) up to which point, losses in your account will be tolerated. This cut point is normally set at 25% of the mandatory margin for the number of lots traded. Once this cut point is reached or breached, your open positions, your trades, will be automatically cut off at a loss without any notification from your own broker; even though the rates return favorably thereafter.
To illustrate once again, as in the example above, since we bought 1 lot, our required margin is $1,000; 25% of this is $250. As the prices continue to go against you, your margin decreases and if it continue to reduction in value and reaches the main point where your remaining margin ( your required margin of $1,000 less your floating loss) is $250, the broker will, without notice whatsoever, liquidate your position automatically.
It is the general practice being followed everywhere and was made to keep the foreign currency market efficient. Without this, a trader may stand to reduce more than what he has deposited and the broker may need to face the responsibility of collecting from losing traders.

Knowing the implication of one’s margin deposit to your trading activities, and getting the knowledge to compute where your cut-points would be every time you initiate a trade are essential to trading foreign currencies successfully. It will give a clearer picture of which trade to take and the financial implications of the chance your consuming every trading opportunity you a

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