Understanding Margin Trading – Implications and Complications

One of the features which attract investors to identify currency trading or retail spot forex is the fact that it really is done by way of a margin trading system that allows investors to maximize the returns for their investments. For example, under the margin trading system, a trader with just a $5,000 deposited in his account can purchase or sell around $500,000 worth of currency contracts. Why don’t we examine how this 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 forex 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 which the trader may incur in the course of his trading activities. In trade for the margin deposit, the broker extends a line of credit to the trader equal to 100 times his margin deposit (200x for other brokers). The trader may 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.
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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 get 100,000 USD.
2) Let’s assume that rate of exchange went around 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 equivalent to:
150,000 Yen/94.50 ———————–$1,587.30
But hold up for one minute there. You need to recognize that this could be the other way around had the trader not bought but sold the dollar instead! The $1,587.30 would have been a loss! And it would have wiped out the initial $1,000 margin focused on the trade and could have started eating up into the remaining trader’s margin deposit.
Now, here 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 overall practice being accompanied by most online brokers is 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 generally 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 undoubtedly 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 the is $250. Because the prices continue to not in favor of 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, with no warning whatsoever, liquidate your position automatically.
It is the general practice being followed everywhere and was designed 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 have to face the burden 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 each and every time you initiate a trade are essential to trading foreign currencies successfully. It will provide a clearer picture of which trade to take and the financial implications of the risk your taking in every trading opportunity you a

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