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 through a margin trading system which allows investors to maximize the returns for his or her 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 that is possible.

In accordance with “Wikipedia”, ‘ a margin is really a collateral that the holder of a posture in securities, options, or futures contracts must deposit to cover the credit threat of his counter-party (most often his broker).
In online spot currency trading, the investing of currencies are done in tranches or by lots of $100,000 each. When 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 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 using the amount 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 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) Assuming 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 at this level, he will realize a profit of 150,000 Yen computed as follows:
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
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Net Profit ————————————-150,000 Yen
At the existing exchange rate this is equivalent to:
150,000 Yen/94.50 ———————–$1,587.30
But hold up for a 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 could have wiped out the initial $1,000 margin committed to the trade and would 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 not in favor of you, the worthiness 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) up to which point, losses in your account will be tolerated. This cut point is normally set at 25% of the required margin for the number of lots traded. Once this cut point is reached or breached, your open positions, your trades, will undoubtedly be automatically cut off baffled without any notification from your own 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 the is $250. Because the prices continue to not in favor of you, your margin decreases and if 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, without notice whatsoever, liquidate your position automatically.
This is actually the general practice being followed everywhere and was made to keep the forex market efficient. Without this, a trader may stand to lose more than what he has deposited and the broker may have to face the burden 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 each and every time you initiate a trade are essential to trading foreign currency successfully. It will give a clearer picture which trade to take and the financial implications of the chance your consuming every trading opportunity you a

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