Forex Margin Trading

 

In the previous chapter we compare work at Forex with opportunity to gain on the buy/sell operations in exchange office. It is obvious that Forex has a range of advantages which allow traders to take significant profit in a short period of time. The main benefit which may also be called “the base of pyramid” of such earning is Margin Trading which was introduced in Forex in 1986.

 

Margin trading allows investors with comparatively small capital work on Forex market. Without it private investors will not be able to trade, because marginal amount of contract on Forex (1 lot) is about 100 000 US dollars (1 lot volume in WWL is 10 000 US Dollars and it is 10 times less than standard market lot). The principal of margin trading is as follows. Stock intermediary (Internet broker or Dealing Company) issues a loan to its clients for operations with currencies, charged upon client’s money called security deposit. The amount of security deposit is 1-5% of the deals size made by a client on Forex and depends on the leverage. Leverage can be 1:20, 1:50, 1:100 and even 1:500 and depends on the conditions of a certain Internet broker. It means that having security deposit in amount of $1 000, a client can get as a credit from 20 000 to 500 000 US dollars for execution of operations at Forex. Opening orders for big sums of money we can get a huge profit. But taking into account the fact that deals are executed with the loan proceeds, the risk of losses increases proportionally to the expectable profit. In other words, we can double the balance of our account as quick as lose everything.

As it was said above, a credit is issued against a pledge of security deposit, which is also called margin deposit or margin (hereof the title margin trading). It means that taking out a loan on speculative activities with currencies on Forex market, a client risks only his only funds. The client may not lose more money that he has in his trading account. In this regard, companies providing intermediary services on the international currency market are fully protected.

 

Why do Internet brokers (dealing centers) allow you a credit on deals execution at Forex? There are several sources of income for such companies and we will consider them in details.

 

Firstly, commission may be charged for every deal a client makes. It means that when you close the order, some amount will be automatically withdrawn from your trading account regardless of whether the deal was profitable or not.

 

Secondly, such companies earn on spread, because they provide higher spread in comparison with real market quotations. Mind that company executes client’s deals in his/her name and for its funds (lent you as a credit) according to the quotations which are provided by bank. Clients get quotes corrected for the Internet broker’s benefit.

 

Thirdly, if a client works with mini or micro lots, he/she in fact “plays” against Internet broker, because neither mini no micro lots are traded in the interbank area. If you get profit, money are paid by the broker itself, if you lose, broker puts your money in its pocket. As such scheme of taking profit works, we can make a conclusion that the most part of beginning traders, trading micro and mini lots, lose their money. In order not to make the same mistakes and not be among them, learn Forex thoroughly before you start trading at the real account.

 

The fourth, a company may add the interest on the given you loan. It means that interest will be added on all positions which weren’t closed by the end of a day. At best, it will be percentage rate (overnight refinancing rate), i.e. rate which the central bank issues commercial banks in the country with. In such case, it is told about bank interest (it is explained in details in the appropriate chapter). Different countries have different interest rates, so depending on the currencies which positions opened with and type of order (buy or sell), bank interest may withdrawn as well as deposited to the client’s account.

 

There is no real delivery of currency in margin trading, and the date of valuation of currencies loses its meaning. Internet trader earns on speculations, opening a deal at one price and closing at another. Traders may work with any currency pair, and not only with currency of his/her security deposit. Moreover, traders may open short positions as well as long ones by any currency pair. All profits and losses are converted in the currency of their security deposit.

 

Let’s consider the principal of margin trading by the example. Suppose that you work with mini lots and expect the upturn of the US dollar rate against the Japanese yen USD/JPY. There are 2000 US dollars at your account, and the size of 1 lot is 10000 US dollars. Suppose that Internet broker provides you with leverage 1:50. It means that to be able to open a deal, you need a security deposit in the amount of 200 US dollars (because 200 x 50 = 10000). In the moment of opening long position the security deposit in the amount of 200 US dollars is frozen, and only 1800 US dollars, which is called free margin, remain at your disposal. You may open other deals only for that amount.

 

It is not recommended to leave too small amount of free margin. The reason is the following: as soon as you opened position, fluctuations of the US dollar against the Japanese Yen could temporary move to the unfavorable for you direction. It means that if you close position at this moment, you will suffer losses which will be withdrawn from your account. Internet broker will not allow you to lose more than you have at your trading account, otherwise it will have to pay from its own pocket. Consequently, as soon as your current (floating) losses will reach the level when your deposit can not cover them, you position will be automatically closed or blocked by the Internet broker.

 

Such automatic closing of position proceeds by so-called margin call, which will be described in details in the next chapter. So more money you have at the account, the wider fluctuations you can stand avoiding margin call. Because the price can change direction to the one you need and you can take profit, but if the size of your account could not withstand temporary negative fluctuation of the rate, you suffer losses.

 

It worth noticing that the more positions (lots) you open, the more funds you need to be kept at your trading account. If considering our example we open not 1 (lot) position but four, then security deposit would be not 200 US dollars but 800. Consequently, free margin would be 1 200 US Dollars. Since temporary loss making rates movements influence all four positions, the chance to receive margin call increases proportionally – by four times! In the next chapter such situation will be described in details.

 

Thus, margin trading gives a range of opportunities to the novice Internet trader. With competent approach to trading it can be the source of your profit growing. But, on the other hand, increase of probable income means increase of risk to lose. So margin trading is “double edged sword”. It can make you rich or poor. Only your intelligence, experience and luck determine your success!