Forex margin trading
Forex margin trading play a great role in forex trading study.
First of all we must know what is the margin?
A private investor who purchases, say, GBP/USD is required to put down a deposit known as margin. Since the sale of one currency involves the purchase of another, the seller of GBP/USD will have bought a volume of USD and will also have to put down margin.
Normal margin requirement is between 1% and 5% of the underlying value of the trade. With 5,000 USD in your margin account and a margin requirement of 2.5%, you can open positions worth 200,000 USD. If the funds in your margin account drop below the minimum required to support your open positions, then you may be asked to provide additional funds. This is known as a margin call.
Margin is the required equity that an investor must deposit to collateralize a position.
Trading on margin means that you can buy and sell assets that represent more value than the capital in your account. Forex trading is usually done with relatively little margin since currency exchange rate fluctuations tend to be less than one or two percent on any given day. To take an example, a margin of 2.0% means you can trade up to $500,000 even though you only have $10,000 in your account.
In terms of leverage this corresponds to 50:1, because 50 times $10,000 is $500,000, or put another way, $10,000 is 2.0% of $500.000. Using this much leverage gives you the possibility to make profits very quickly, but there is also a greater risk of incurring large losses and even being completely wiped out. Therefore, it is inadvisable to maximise your leveraging as the risks can be very high.
In order to attract investors to the FOREX market who wish to risk less than one million dollars at any given time (a standard lot for trading on the exchange market), it employs what is referred to as a margin trade.
Forex Margin trading was created for purposes of potentially advantageous trades of currency in 1985. This process, simply stated, involves a cash deposit, usually much smaller than the underlying value of the currency or commodity contract, is required in order to affect the trade.
The primary distinction between the FOREX trading system from other financial markets, is that foreign currency purchase-sale operations can be made without having a set required sum to perform trading operations. In order to conduct a purchase, a client needs to invest only a small start up amount, which is referred to as a margin.
This gives him an opportunity to make deals in volumes that are 50-100 times greater the start up amount. This so-called shoulder or leverage, is granted by a bank or other credit institution, where the client deposits a guaranteed margin. For example, simply depositing a guaranteed amount of $100,000 in a bank or broker company, enables an individual to make financial operations in amounts of 5 to 10s of millions of dollars. Therefore, even a modest gain on the FOREX market (relative to the input amount) is considered to be of significant size. Another advantage of FOREX is profit derived from any direction of price changing, regardless of the particular currency involved.
Some important terms connected with margin:
Initial margin is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, that is not likely to be exceeded on a usual day's trading.
Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. This is calculated by the futures contract, i.e. agreeing a price at the end of each day, called the "settlement" or mark-to-market price of the contract.
Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. Traders would rarely (and unadvisedly) hold 100% of their capital as margin. The probability of losing their entire capital at some point would be high. By contrast, if the margin-equity ratio is so low as to make the trader's capital equal to the value of the futures contract itself, then they would not profit from the inherent leverage implicit in futures trading. A conservative trader might hold a margin-equity ratio of 15%, while a more aggressive trader might hold 40%.
Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange's perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.