Understanding Margin Trading – Implications and Complications

One of the features which attract investors to spot currency trading or retail spot forex is the fact that it really is done by way of a margin trading system which allows investors to increase the returns for their investments. For example, beneath the margin trading system, a trader with only a $5,000 deposited in his account can purchase or sell around $500,000 worth of currency contracts. Let us examine how that is possible.
According to “Wikipedia”, ‘ a margin is really a collateral that the holder of a position in securities, options, or futures contracts must deposit to cover the credit risk of his counter-party (frequently his broker).
In online spot forex trading, the buying and selling of currencies are done in tranches or by lots of $100,000 each. Whenever a trader opens an account with a broker, his initial margin deposit serves as a collateral to cover future losses which the trader may incur throughout his trading activities. In trade 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 based on the number of lots the trader has bought or sold.
To illustrate this, view the example below:
Trader A opens an account with Broker B with a $5,000 deposit. He buys 1 lot 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 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 existing exchange rate this is equal to:
150,000 Yen/94.50 ———————–$1,587.30
But hold up for one minute there. You need to recognize 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 initial $1,000 margin committed to the trade and would have started eating up into 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 value of the contracts you’re holding will depreciate in value much like our computation above…and much more important, your margin deposit may also depreciate in equivalent value. The general practice being followed by most online brokers would be to set a cut point (called officially as margin call point) around which point, losses in your account will undoubtedly be tolerated. This cut point is normally set at 25% of the mandatory margin for the amount 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 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 not in favor of you, your margin decreases and when 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.
This is the general practice being followed everywhere and was designed to keep the forex market efficient. Without this, a trader may stand to lose more than what he’s got deposited and the broker may have to face the responsibility of collecting from losing traders.
Knowing the implication of your margin deposit to your trading activities, and having the knowledge to compute where your cut-points will be every time you initiate a trade are essential to trading foreign currency successfully. It will provide a clearer picture which trade to take and the financial implications of the chance your taking in every trading opportunity you a

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