Wednesday, August 4, 2010

Understanding Margin Trading - Implications and Complications

One of the features which attract investors to spot currency trading is the fact that it is done through 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 buy or sell up to $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 position in securities, options, or futures contracts has to deposit to cover the credit risk of his counterparty (most often his broker).
Richard Alcantara, EzineArticles.com Basic AuthorIn online spot currency trading, the buying and selling 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 in the course of his trading activities.  In exchange 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 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 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 9,300,000Yen from the broker to buy 100,000 USD.
             2) Assuming that rate of echange 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 will actualize a profit of 150,000Yen 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
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 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 would have been 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 rest of the 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 are holding will depreciate in value similar to our computation above...and more important, your margin deposit will also depreciate in equivalent value. The general practice being followed 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 generally 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 be automatically cut off at a loss 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. As the prices continue to go against you, your margin decreases and if it continue to decrease in value and reaches the 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 foreign currency 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 would be every time you initiate a trade are essential to trading foreign currencies successfully. It will give a clearer picture of which trade to take and the financial implications of the risk your taking in every trading opportunity you are about to take...before you take them.
                        
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