One of the features which attract investors to identify currency trading or retail spot forex is the fact that it is done through a margin trading system that allows investors to maximize the returns for their investments. For example, under the margin trading system, a trader with only a $5,000 deposited in his account can purchase or sell around $500,000 worth of currency contracts. Why don’t we examine how this 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 (frequently his broker).
In online spot currency trading, the investing 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 which the 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 equivalent 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 using the amount of lots the trader has bought or sold.
To illustrate this, view the example below:
Trader A opens an account with Broker B with a $5,000 deposit. He buys 1 large amount of USD against yen at the current 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 get 100,000 USD.
2) Let’s assume that rate of exchange went up to 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 sell his dollars as of this level, he’ll realize a profit of 150,000 Yen computed the following:
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 current exchange rate this is equivalent to:
150,000 Yen/94.50 ———————–$1,587.30
But hold up for one minute there. You need to realize that this could be the other way around had the trader not bought but sold the dollar instead! The $1,587.30 would have been 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 remaining trader’s margin deposit.
Now, here is what every trader must understand clearly (the complications). Because the prices start to not in favor of you, the value of the contracts you are holding will depreciate in value similar to our computation above…and much more important, your margin deposit will also depreciate in equivalent value. The general practice being followed by most online brokers would be to set a cut point (called officially as margin call point) around which point, losses in your account will be tolerated. This cut point is generally set at 25% of the required margin for the amount of lots traded. Once this cut point is reached or breached, your open positions, your trades, will be automatically cut off baffled 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 not in favor of you, your margin decreases and if it continue to reduction 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, without notice whatsoever, liquidate your situation automatically.
Here is the general practice being followed everywhere and was made to keep the foreign currency 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 each time you initiate a trade are crucial to trading foreign currencies successfully. It will provide a clearer picture of which trade to take and the financial implications of the chance your taking in every trading opportunity you a