Among the features which attract investors to spot currency trading or retail spot forex trading is the fact that it is done through a perimeter trading system which allows investors to maximize the returns for their investments. For example , under the margin trading system, an investor with just a $5, 000 deposited in his account can buy or market up to $500, 000 worth of currency contracts. Let us examine just how this is possible.
According to “Wikipedia”, ‘ a margin is a collateral how the holder of a position in investments, options, or futures contracts needs to deposit to cover the credit risk of his counter-party (most frequently his broker).
In online spot currency trading, the buying and selling of foreign currencies are done in tranches or simply by lots of $100, 000 each. Every time a trader opens an account with a broker, his initial margin deposit is a collateral to cover future losses which the trader may incur during his trading activities. In exchange for your margin deposit, the broker expands a credit line to the trader equivalent to 100 times his margin deposit (200x for other brokers). The trader can then trade up to five lots or $500, 000 worth of currencies. Profits and losses are computed based on the number of a lot the trader has bought or sold.
To illustrate this, view the example below:
Trader A opens an account with Broker B having a $5, 000 deposit. He buys 1 lot of USD against yen at the current exchange rate associated with 93. 00Y to $1.
1) He commits $1, 000 of his margin deposit to the industry as collateral and borrows nine, 300, 000 Yen from the agent to buy 100, 000 USD.
2) Assuming that rate of exchange went up to 94. 50Y to $1, the trader’s $100, 000 (1 lot) will now be worth hundred buck, 000X94. 50 = 9, 450, 000 Yen.
3) If the investor decides to sell his dollars at this level, he will realize a profit associated with 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 current exchange rate this is equivalent to:
150, 1000 Yen/94. 50 ———————–$1, 587. thirty
But hold up for a minute right now there. You need to realize that this could be the other method around had the trader not bought but sold the buck instead! The $1, 587. 30 would have been a loss! And it would have worn 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 single trader must understand clearly (the complications). As the prices start to go against you, the value of the contracts you happen to be holding will depreciate in worth similar to our computation above…
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and much more important, your margin deposit may also depreciate in equivalent value. The overall practice being followed by most online brokers is to set a cut point (called officially as margin call point) up to which stage, losses in your account will be tolerated. This cut point is generally established at 25% of the required margin for the number of lots traded. As soon as this cut point is attained or breached, your open roles, your trades, will be automatically cut off at a loss without any notification from your agent; even if the rates return favorably thereafter.
To illustrate once more, as in the particular example above, since we bought 1 lot, our required perimeter is $1, 000; 25% of the is $250. As the prices continue to keep go against you, your margin decreases and if it continue to decrease in value and reaches the point where your leftover margin ( your required margin of $1, 000 less your own floating loss) is $250, the particular broker will, without notice whatsoever, liquidate your position automatically.
This is the general practice being followed everywhere and was created to keep the foreign currency market effective. 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 investors.
Knowing the implication of your margin down payment to your trading activities, and getting 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 more clear picture of which trade to take and the financial implications of the risk your own taking in every trading opportunity you might be about to take… before you take them.