Understanding Margin Trading – Implications and Complications

One of the features which attract investors to spot forex trading or retail spot forex is the fact that it really is done through a margin trading system that allows investors to increase 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. Let us examine how that is possible.
In accordance with “Wikipedia”, ‘ a margin is really a collateral that the holder of a position 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. When a trader opens an account with a brokerage, 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 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 existing 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 sell his dollars as of this level, he’ll 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
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 another 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 original $1,000 margin focused on the trade and could have started eating up into the rest of the trader’s margin deposit.
Now, this is what every trader must understand clearly (the complications). Because the prices start to go against you, the worthiness 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 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 be tolerated. This cut point is normally set at 25% of the mandatory 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 own broker; even though 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. As the prices continue to go against 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, with no warning whatsoever, liquidate your position automatically.
This can be 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 need to face the responsibility of collecting from losing traders.
Knowing the implication of one’s margin deposit to your trading activities, and getting the knowledge to compute where your cut-points will be every time you initiate a trade are crucial to trading foreign currencies successfully. It will provide a clearer picture which trade to take and the financial implications of the risk your taking in every trading opportunity you a

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