Understanding Margin Trading – Implications and Complications

One of the features which attract investors to identify currency trading or retail spot forex may be the fact that it is done by way of a margin trading system that allows investors to increase the returns because of their investments. For example, beneath the margin trading system, a trader with only a $5,000 deposited in his account can purchase or sell up to $500,000 worth of currency contracts. Why don’t we 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 must deposit to cover the credit threat of his counter-party (frequently his broker).
In online spot forex trading, the investing of currencies are done in tranches or by lots of $100,000 each. Whenever 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 equal to 100 times his margin deposit (200x for other brokers). The trader may then trade around 5 lots or $500,000 worth of currencies. Profits and losses are computed using 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 large amount 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 buy 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 will 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 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 another 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 committed to the trade and could have started eating up into the remaining trader’s margin deposit.
Now, here’s what every trader must understand clearly (the complications). As 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 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 generally 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 undoubtedly be automatically cut off at a loss without any notification from your broker; even though 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 this is $250. As the prices continue to go against you, your margin decreases and if it continue to reduction 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, without notice whatsoever, liquidate your position automatically.

This can be a general practice being followed everywhere and was designed to keep the forex market efficient. Without this, a trader may stand to reduce 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 will be every time you initiate a trade are crucial to trading foreign currencies successfully. It will give a clearer picture which trade to take and the financial implications of the chance your consuming every trading opportunity you a