In the previous chapter we compared work on Forex with the opportunity to earn from the buy/sell operations at an exchange office. It is obvious that Forex has a range of advantages that allow traders to take significant profit in a short time. The main benefit, which can also be called “the base of the pyramid” of such earnings, is margin trading introduced on Forex in 1986.
Margin trading allows investors with comparatively small capital work on the forex market. Without it, private investors will not be able to trade, because the marginal amount of a contract on Forex (1 lot) is about 100,000 US dollars (1 lot on InstaForex is 10,000 US Dollars and it is 10 times smaller than the standard market lot). An intermediary (brokerage or dealing firm) issues a loan to its customer for operations with currencies, which is credited plus to the customer’s money called a security deposit. The amount of the security deposit is 1-5% of the order size made by the customer, it 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 broker. It means that having a security deposit in the amount of $1,000, a trader can get from $20,000 to $500,000 for execution of operations on Forex as a credit. Opening positions for a big amount of money, we can get a huge profit. But as the trades are executed with the loan, the risk of loss increases proportionally to the expected profit. In other words, we can double the balance of our account as quickly as lose everything.
As it is said above, a credit is issued against a pledge of security deposit, which is also called margin deposit or margin (that is where the margin trading came from). It means that, taking out a loan on speculative activities with currencies on the forex market, a customer risks only his only funds. The customer cannot 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 brokers (dealing firms) allow you a credit on Forex trading? There are several sources of income for such companies, and we will consider them in detail.
Firstly, they can charge a commission for every trade a client makes. It means that when you close a trade, some amount is automatically withdrawn from your trading account regardless of whether your position was profitable or not.
Secondly, such companies earn on spread, because they provide higher spread in comparison with spread they get from real market quotes. Mind that the company executes the client's trades in its name and for its funds (lent you as a credit) according to the quotes provided by the bank. Clients see quotes with marked-up spread.
Thirdly, if a client works with mini or micro lots, he in fact “plays” against the broker, because neither mini, nor micro lots are traded on the interbank. If you get profit, money is paid by the broker, if you lose, the broker puts your money in its pocket. As such a scheme of taking profit works, we can make a conclusion that most novice 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 on a live account.
A company can add the interest on the loan given to you. It means that interest will be added on all the positions that weren’t closed by the end of the day. At best, it will be a percentage rate (overnight refinancing rate), i.e. the rate provided by the central bank to the commercial banks in the country. In such a case, it is told about bank interest (it is explained in detail in the corresponding chapter). Different countries have different interest rates, so depending on the currencies of a trade and its type (buy or sell), the bank interest is withdrawn from or 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 traders earn on speculations, opening a position at one price and closing at another. Traders may work with any currency pair regardless of the currency they made a deposit in. 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 principle of margin trading in an 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 2,000 US dollars in your account, and the size of 1 lot is 10,000 US dollars. Suppose that your broker provides you with 1:50 leverage. It means that to be able to open a position, you need a security deposit in the amount of 200 US dollars (because 200 x 50 = 10,000). At the moment of opening the position the security deposit in the amount of 200 US dollars is frozen, so you have only 1,800 US dollars available, which is called free margin. You can open other deals only for that amount.
It is not recommended leaving small free margin. The reason is the following: as soon as you opened a position, fluctuations of the US dollar rate against the Japanese yen could temporarily move to the direction unfavorable for you. It means that, if you close the position at this moment, you will suffer losses, which will be withdrawn from your account. A broker will not allow you to lose more than you have in your trading account, otherwise it will have to pay from its own pocket. Consequently, as soon as your current (floating) losses reach the level when your deposit can not cover them, your position will be automatically closed or blocked by the broker.
Such automatic closing of position is preceded by a so-called margin call, which will be described in details in the next chapter. So more money you have in the account, the sharper fluctuations you can stand avoiding margin calls. The price can change direction to the one you need and you can take profit, but if your balance cannot withstand the temporary negative fluctuation, you will suffer losses.
The more positions (lots) you open, the more funds you need to be kept in your trading account. In our example we open not 1 (lot) position but four, so the security deposit is not 200 US dollars but $800. Consequently, free margin would be 1,200 US Dollars. Since temporary loss making rate movements influence all four positions, the chance to receive margin call increases proportionally – by four times! In the next chapter such a situation will be considered in detail.
Thus, margin trading gives a range of opportunities to the novice trader. With a competent approach to trading it can be the source of your profit. 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!