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    Understanding Margin Trading – Implications and Complications

    One of the features which attract investors to identify forex trading or retail spot forex may be the fact that it really is done through a margin trading system which allows investors to maximize the returns for their investments. For example, beneath the margin trading system, a trader with just a $5,000 deposited in his account can purchase or sell around $500,000 worth of currency contracts. Let us examine how that is possible.
    According to “Wikipedia”, ‘ a margin is really a collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk of his counter-party (most often his broker).
    In online spot forex trading, the buying and selling of currencies are done in tranches or by lots of $100,000 each. When a trader opens a merchant account with a brokerage, his initial margin deposit serves as a collateral to cover future losses that your trader may incur in the course of his trading activities. In exchange for the margin deposit, the broker extends a line of credit 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 in line with the number of lots the trader has bought or sold.
    To illustrate this, view the example below:
    Trader A opens a merchant account with Broker B with a $5,000 deposit. He buys 1 lot 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) Assuming that rate of exchange went around 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 at this level, he’ll realize a profit of 150,000 Yen computed as follows:
    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 existing exchange rate this is equal to:
    150,000 Yen/94.50 ———————–$1,587.30
    But hold up for one 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 focused on the trade and would have started eating up in to the rest of the trader’s margin deposit.
    Now, here’s what every trader must understand clearly (the complications). Because the prices start to not in favor of you, the worthiness of the contracts you’re holding will depreciate in value much like our computation above…and much more important, your margin deposit may 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 undoubtedly be tolerated. This cut point is normally 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 be automatically cut off at a loss without any notification from your broker; even if the rates return favorably thereafter.
    To illustrate once more, as in the example above, since we bought 1 lot, our required margin is $1,000; 25% of this is $250. Because the prices continue to go against you, your margin decreases and if it continue to decrease 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, with no warning whatsoever, liquidate your position automatically.
    Here is the general practice being followed everywhere and was made to keep the forex market efficient. Without this, a trader may stand to lose more than what he has deposited and the broker may have to face the responsibility 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 would be every time you initiate a trade are essential to trading foreign currencies successfully. It will give a clearer picture which trade to take and the financial implications of the chance your taking in every trading opportunity you a

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