Chapter 1 How Does Margin Work?
Many people think that investing in a foreign currency sounds exotic and full of uncertainty. However, a surprising number of investors are moving into alternative investments like foreign currency to counter the increasingly volatile stock market.
It’s exactly because of the uncertainties that investors face in today’s world that it makes sense to invest in foreign currencies.
What Is Margin?
Margin refers to the amount of your own money you have to deposit with the broker in order to begin trading.
The foreign exchange margin trading was originally generated in London in the 1980s. It is an investor’s foreign exchange trading with a trust provided by a bank or broker. It makes full use of the principle of leveraged investment, a kind of forward foreign exchange trading between financial institutions and investors.
In the transaction, investors can make 100% of the transaction only by paying a certain margin, so that investors with small funds can participate in the financial market for foreign exchange transactions.
According to the level of developed countries, the general leverage ratio is maintained at 10-20 times. In other words, if the leverage ratio is 20 times, then investors can trade foreign exchange as long as they need to pay a margin of about 5%. That is, investors can pay $5,000 for a $100,000 foreign exchange transaction.
For example, investor A starts forex trading with a margin ratio of 1%. If the investor expects the yen to rise, then he can go short on the USD/JPY at a contract value of 10 million US dollars (100,000 ÷ 1%).
When the USD/JPY price drops by 1 pip, investors can make a profit of 100,000 Japanese Yen ($10 million × 1 pip change = ¥100,000). Similarly, if the USD/JPY rises by 1 pip, then the investor will lose 100,000 Japanese Yen.
Characteristics of Forex Margin Trading
1. Forex trading can be operated in both directions, which gives more flexibility and choices to investors.
2. 24 hours and T+0 trading mode, which means an order can be placed at any time during weekdays.
3. Positions will not get expired, so investors can hold positions for a very long time, provided that investors have sufficient funds in the account. Otherwise, a margin call may be triggered.
4. All convertible currencies can be traded.
Margin vs Non-margin
Suppose Investor A and Investor B have bought 1 million units (or 10 standard lots) of EUR/USD at a price of 1.2100 respectively.
Investor A uses margin (assuming a margin requirement of 1%), then he only needs to deposit €12,100.
On the other hand, Investor B has no margin to use, so he could only deposit €1,210,000.
Let’s consider two circumstances of appreciation and depreciation of the EUR.
Case 1: Appreciation
If the EUR/USD exchange rate rises to 1.2150, or by 50 pips, then both investors can make a profit of 1 million units × (1.2150-1.2100) = $5,000, which can be converted to €4115.23 at a EUR/USD exchange rate of 1.2150.
Investor A has a Return on Investment (ROI) of €4115.23 ÷ €12,100 = 34.01%.
Investor B has a ROI of €4115.23 ÷ €1,210,000 = 0.34%.
Case 2: Depreciation
If the EUR/USD exchange rate has fallen by 50 pips to 1.2050, then both investors would suffer a loss of 1 million units × (1.2100-1.2050) = $5,000, which can be converted to €4149.38 at a EUR/USD exchange rate of 1.2050.
If the EUR/USD exchange rate keeps falling to 1.1800 (by 300 pips), then both Investors would suffer a total loss of 1 million units ×(1.2100-1.1800) = $300,000, which can be converted to €254,237.29.
Investor B has €1,210,000 - €254,237.29 = €955,762.71 left.
In theory, Investor A would have lost the same amount of money, which is more than his deposit of €12,100. But in forex trading, continuous loss would trigger a margin call, which would prevent traders from having a negative account. Therefore, Investor A would only loss his deposit of €12,100. In other words, Investor avoid a further loss of €254,237.29 - €12,100 = €242,137.29
