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 for his or her investments. For example, beneath the margin trading system, a trader with just a $5,000 deposited in his account can purchase or sell up to $500,000 worth of currency contracts. Why don’t we examine how this is possible.
In accordance with “Wikipedia”, ‘ a margin is really a collateral that the holder of a posture in securities, options, or futures contracts has to deposit to cover the credit threat of his counter-party (most often his broker).
In online spot forex trading, the investing of currencies are done in tranches or by plenty of $100,000 each. Whenever a trader opens a merchant account with a brokerage, 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 equal to 100 times his margin deposit (200x for other brokers). The trader can then trade up to 5 lots or $500,000 worth of currencies. Profits and losses are computed using 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 lot of USD against yen at the current 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 buy 100,000 USD.
2) Let’s assume 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 at this level, he’ll 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 focused on the trade and could have started eating up in to the remaining trader’s margin deposit.

Now, this is what every trader must understand clearly (the complications). As the prices start to go against you, the worthiness of the contracts you are holding will depreciate in value similar to our computation above…and much more important, your margin deposit will also depreciate in equivalent value. The overall practice being followed by most online brokers would be 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 baffled without any notification from your broker; even if the rates return favorably thereafter.
To illustrate once more, as in the example above, since we bought 1 lot, our required margin is $1,000; 25% of this is $250. Because the prices continue to not in favor of you, your margin decreases and when it continue to decrease 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, with no warning whatsoever, liquidate your situation automatically.
Here is the general practice being followed everywhere and was made to keep the forex 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 having the knowledge to compute where your cut-points would be every time you initiate a trade are crucial to trading foreign currencies successfully. It will give a clearer picture of which trade to take and the financial implications of the risk your consuming every trading opportunity you a