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 which 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. Let us examine how this is possible.

According to “Wikipedia”, ‘ a margin is 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 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 equivalent 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 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 large amount 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 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 market his dollars as of 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 a minute there. You need to realize that this could be the other 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.
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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 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) 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 amount 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 if 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. As the prices continue to not in favor of you, your margin decreases and when it continue to reduction in value and reaches the stage where your remaining margin ( your required margin of $1,000 less your floating loss) is $250, the broker will, without notice whatsoever, liquidate your situation automatically.
This can be a 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’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 would be each and every time you initiate a trade are essential to trading foreign currency successfully. It will give a clearer picture of which trade to take and the financial implications of the chance your taking in every trading opportunity you a

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