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Task №5. Margin trading on Forex. Principles behind trading on financial floors.

Margin trading makes Forex attractive both for big investors and individuals. It gives access to the market to those clients who lack large funds. A standard lot for trading with InstaForex makes up 10,000 US dollars, thus allowing participants to conduct transactions with the minimum deposit of 1 US dollar.

The essence of margin trading is that you need just a small part of a whole contract sum to carry out a deal. To buy or sell a currency, traders need to fund a guarantee deposit to a bank or other brokerage company and then they will receive leverage. Such a use of investment capital enables a market player to manage a relatively large amount through quite small funds thanks to a loan. A trader then buys currencies, shares or other assets for borrowed money, now being able to make deals that exceed the initial deposit by 50-100 times. In other words, purchasing currencies with a margin means concluding a contract that is partially paid out by the credit given to you by a broker. That is why, even a modest profit or loss compared to the deposited sum is a considerable figure. There are two margin types: fixed and percentage. In case a fixed margin is required for a trading position, a trader needs to have a certain sum on their account to fulfill obligations regarding the chosen leverage.

Let’s consider an example. Suppose, there is 1:100 leverage and a standard lot of 10,000 units of a trading currency. To open a one-lot deal, a margin of 100 units of the deposited currency is needed.

It will be as follows: 10,000 / 100 = 100. It does not matter what currency is used in a deal and what currency is deposited as a margin.

A percentage margin creates another situation. In this case, a trader needs to provide the margin that equals a fixed percentage (according to leverage requirements) of a trading sum. Calculations of this sum consider a current currency exchange rate.

It may look like as follows: depositing currency – US dollar, percentage margin – 1% of a deal size. A trader conducts a deal on the EUR/USD pair of 1 lot (10,000 euros). The exchange rate at the moment of deal execution:

  bid ask
EUR/USD 1.2050 1.2053

Let’s calculate the needed margin:

1% of 1 lot = €10,000 * 1 / 100 = €100

Our margin totals 100 euros. However, a trader needs to find out how many greenbacks make up 100 euros because the margin is denominated in the US dollars. Taking into account the exchange rate, the sum is calculated as follows:

€100 = €100 * $1.2053 (ask) = $120.53 = $120.6 (approximated)

For example:

1. Suppose the euro exchange rate against the US dollar (EUR/USD) equals 1.2505/1.2508. Let’s say you have carried out currency market analysis (we will touch on this issue in next lessons) and you believe that the euro/dollar pair will go up to 1.2600. You buy 1 EUR/USD lot for the ask price of 1.2508. Our deal size is 10,000 euros (1.0 lot of EUR/USD is 10,000 euros). So you buy 10,000 euros and pay 10,000*1.2508 = 12,508 US dollars. To conduct a deal, you do not have to possess this whole sum, but only 100 dollars. Your broker, that is the company giving you access to Forex, provides you with the needed amount as a credit. Suppose, you have made the right forecast and EUR/USD reaches 1.2599/1.2602. You fix profits - close the position by opening an opposite deal. In our case, you sell euros at the bid price of 1.2599. So you sell 10,000 euros and receive 12,599 dollars with the profit of 91 dollars. But you deposited only 100 euros instead of 10,000 euros to make a deal. Your profit equals: 1.2599 - 1.2509 = 0.0090, or 90 pips. A pip is, as you already know, the smallest unit of a price change.

Deal balance
+10000 eur -12508 usd
-10000 eur +12599 usd
0 +91 usd

Thanks to the opposite - offset - deal, you managed to fix profits that will be added to a deposited margin. Besides, you paid off the credit provided by your broker.

2. However, your forecast may turn out to be wrong. Let’s see what to do in this case. The price dropped and EUR/USD is trading at the levels of 1.2419-1.2422. You need to pare losses, to conduct an offset (opposite) deal and fix losses.

Deal balance
+10000 eur -12508 usd
-10000 eur +12419 usd
0 -89 usd

The loss of 89 US dollars will be taken from the security deposit (margin). This case shows the necessity to make a security deposit. The fact is that a broker does not want to suffer losses because of your losing deals. That is why there is a scheme of security deposits (margin), which helps you meet your obligations.

Since physical delivery of currency is not typical of the margin trading, the payment method is based on netting. Netting is a method of payment for performed deals. The main idea of netting is not to send a full amount of an asset, but to send only the final sum of performed deals, in case counter agents buy and sell the same volume of base currencies. Mutual compensation of liabilities, assets, and bank balances between offices of financial companies or between banks allows them to avoid bank commissions and reduces currency risks. Such method has been used for a long time in the interbank trading. Let’s look at the example of the interaction of bank A and bank B.

Bank A bought 1,000,000 euros for the US dollars from bank B. The exchange rate is 1.2050. That day, bank A decided to sell 1,000,000 to bank B at the exchange rate of 1.2060.

Pattern of the current situation is the following: having bought 1,000,000 euros bank A owed bank B 1,205,000 US dollars whereas bank B owed bank A 1,000,000 euros. When bank A performed the opposite operation, i.e. sold 1,000,000 euros to bank B for 1,206,000 US dollars, both banks received an opportunity to make an offset of the main deal sum and to make the final payment. In this case, bank B should send the difference of 1,000 US dollars to the bank A.

This example shows that netting is a payment between a particular broker and a trader.

Brokers establish a particular level of margin to prevent themselves and their clients from risks. When a position reaches a particular margin level, it is forcedly closed. Thus, the opposite deals are performed without traders’ participation. InstaForex establishes the limiting level at 30% from the initial margin. Consequently, a client’s losses on open deals can amount to 70% from the initial sum. For example, a trader made a deposit of 1,000 US dollars. (Initial margin), unrealized gain/loss (the current result on open deals) totals 700 US dollars. Thus, the current balance (a deposit volume increased or decreased by the sum of unrealized gain/loss) is 1,000 US dollars – 700 US dollars = 300 US dollars that is 30% of the initial sum. According to the established rules, a broker has a right to close forcedly its clients’ deals and fix their losses. If there are several open positions, for example three positions with the size of one lot each, the position which brought the largest loss will be closed first. Let us suppose that a trader made a deposit of 3,000 US dollars. There are three open positions with the size of 1 lot each (30,000 US dollars). It is obvious that the initial margin totals 3,000 US dollars. However, all the positions are unsuccessful, and the loss amounts to 2,100 US dollars. In the Balance field you will see the sum of 900 US dollars that is 30% from the initial margin (30% from 3,000 US dollars). In this case, a broker will initiate a forced deals’ closure. A position with the largest floating loss will be closed first.

This approach prevents traders from losing the whole deposit and owing money to a broker and other market participants.

If deals are not closed by the end of the day (by 00:00), a trader has to pay a commission as these deals were rolled over the night. The commission is taken for using credit resources as after midnight a new day of their usage starts. However, our clients can open a swap-free account (no commissions are taken for the position rollover). The swap-free accounts are usually called Islamic, because initially these accounts were established for the traders following the Islamic religion.

In the Balance field of the MetaTrader 4 trading platform you can see the size of the security deposit, which funds will be used for margin to open positions. The sum depends on the results of the performed deals. You can see it in the Gain/Loss filed. In case of a successful deal, the sum will be increased whereas in case of a loss, it will be reduced.

In the Free margin field you can see the sum, which can be used as a margin to open additional positions. Leverage is a very important tool that increases profits from trading operations. At the same time, it indicates traders’ risks.

Helpful information for the MetaTrader users

On our website you can get more detailed information on the initial margin size and fees charged for a position rollover.

Questions for revision
  1. What is a margin?
  2. How can you explain the following: leverage of 1:50; calculate the necessary margin for the leverage of 1:50 in order to open a position with the size of 1 lot (10,000 units).
  3. Find the sum of free margin, if:
    • - balance is 3,000;
    • - unrealized gain/loss is -300;
    • - fixed gain/loss is 250;
    • - initial margin is 1,000;
    • - commission is 20.

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