Chapter 10. Margin trading

In the previous chapter, working in the Forex market was compared to the possibility of earning money from buying/selling operations in an exchange office. It was shown that Forex has a number of advantages that allow you to get significant income in a short period of time. The main advantage at the “base of the pyramid” of such earnings is margin trading, which was first introduced in Forex in 1986.

Margin trading allows investors with relatively small capital to work on the Forex market. Without it, the work on the currency exchange of private investors would be impossible, since the minimum amount of a Forex contract (one lot) is about 100,000 US dollars. The principle of margin trading is as follows. An exchange intermediary (an Internet broker or a dealing company) grants its clients a loan for currency speculation on the security of funds available to the client, called an insurance deposit. The size of the security deposit is usually 1-5% of the size of the client’s Forex trades and depends on the amount of leverage provided. Leverage can be 1:20, 1:50, 1:100 and even 1:200 and depends on the conditions of a particular Internet broker. This means that, having a security deposit of $1,000, a client can get a loan from $20,000 to $200,000 for making transactions on Forex. By making transactions for larger amounts, we can get more profit. But since in this case the trades are made with borrowed funds, the risk of loss increases in proportion to the probable profit. In other words, we can double the amount in our account as quickly as we can lose it all.

As we have already mentioned, a loan is provided against a security deposit, which is also called a security deposit or margin (hence the name margin trading). This means that by obtaining a loan for speculation with currency on the Forex market, the client risks only his own funds. The client cannot lose more funds than he has on his security deposit. In this respect, companies providing intermediary services in the international currency market are fully protected.

What is the point of Internet brokers (dealing companies) to provide you with a loan to make Forex trades? There are several sources of income for such companies, which we will talk about in detail.

First, the company may charge a commission for each trade made by the client. This means that when you close a position, a certain amount of money is automatically deducted from your account, regardless of whether the trade made you a profit or a loss.

Secondly, such companies earn on the spread, as they provide their clients with a slightly higher spread compared to real market quotations. After all, at the client’s order, the company makes transactions on its own behalf and for its own funds (as if given to you on credit) at the quotes given to it by the bank. Clients receive quotes adjusted to the favorable side for the Internet broker.

Thirdly, if the client works with mini or micro lots, he is essentially “playing” against the Internet broker, as mini and micro lots are not traded at the interbank level. In case of profit, the funds are paid directly by the Internet broker, and in case of loss, your funds are received by the Internet broker. Since such a scheme of profit making by dealing companies works, we can conclude that the majority of novice traders working with mini and micro lots lose their money. In order not to repeat their mistakes and not to be such a “majority”, thoroughly study Forex before you start working with a real account.

Fourth, the company may charge interest on the credit extended to you. This means that interest is charged on the amount of all open positions carried over to the next day (i.e., not closed at the end of the day). In the best case it will be the interest rate (refinancing rate), i.e. the rate at which the Central Bank lends to commercial banks in the country. In such a case, one speaks of bank interest (discussed in detail in the relevant chapter). Different countries have different interest rates, so depending on the currencies of open positions and the type of transaction (buying or selling), bank interest can either be charged to the customer or accrue to the customer.

In margin trading, there is no real delivery of currency, and the value date loses its meaning. An internet trader makes money on speculation by opening a position at one price and closing it at another. Traders can work with any currency pair, not just the currency of their security deposit. Moreover, traders can open both long and short positions on the currency pair they are interested in. All profits and losses are converted into the currency of the insurance deposit.

Let’s consider the principle of margin trading by example. Let’s assume that you work with mini lots and expect the growth of the dollar rate against the Japanese Yen USD/JPY. You have USD 2,000 in your account and the size of one mini lot is equivalent to USD 10,000. Suppose your online broker provides you with a leverage of 1:50. This means that in order to open a position, you need a security deposit of $200 (i.e. 200 x 50 = 10,000). When you open a long position in your account, the amount of the security deposit is frozen and only $1,800, called the free part of the account, is at your disposal. You can use it to open other positions.

Leaving too little free money in your account is not recommended. The fact is that as soon as you open a position, the fluctuations in the dollar/yen exchange rate can temporarily go in a direction that is unfavorable for you. This means that if you close the position at that moment, you will incur losses that will be deducted from your account. An online broker cannot allow your losses to be greater than the size of your account, otherwise he will have to pay extra “out of pocket”. Therefore, as soon as your current (floating) losses reach the point when your account will not be able to cover them, your position will be automatically closed or locked by the Internet broker (locking positions will be discussed in the Forex University section). This automatic closing of a position is preceded by a so-called margin call, which will be described in detail in the next chapter. Thus, the larger the amount on your account, the greater fluctuations of the rate on an open position you can withstand, avoiding the margin call. After all, the direction of the exchange rate can change in the direction you want and bring you profit, but if the size of your account could not withstand a temporary negative fluctuation of the exchange rate, you will incur losses.

It should be noted that the more positions (lots) you open, the more free funds you should have on your account. If in our example with the U.S. dollar and the Japanese Yen we would open not one lot but four, the security deposit would not be $200 but $800. Therefore, the free part of the account would be $1,200. Since temporary unprofitable rate fluctuations are now reflected in all four open positions, the chance of getting a margin call increases proportionally – four times! This situation will be discussed in detail in the next chapter.

So, margin trading gives a number of advantages to a novice Internet trader. With a competent approach to trading, it can become a source of increasing your income. But, on the other hand, an increase in possible income means an increase in the risk of losses. Therefore, margin trading is a two-way street. It can make you very rich, or very poor. Only your intelligence, forex practice and a share of luck determine your success!