"How to Trade the Forex Market" with Leverage
Leverage financed with credit, such as that purchased on a margin account is very common in Forex. A margined account is a leverage able account in which Forex can be purchased for a combination of cash or collateral depending what your brokers will accept. The loan(leverage) in the margined account is collateralized by your initial margin (deposit), if the value of the trade (position) drops sufficiently, the broker will ask you to either put in more cash, or sell a portion of your position or even close your position. Margin rules may be regulated in some countries, but margin requirements and interest vary among broker/dealers so always check with the company you are dealing with to ensure you understand their policy.
Up until this point you are probably wondering how a small investor can trade such large amounts of money (positions). The amount of leverage you use will depend on your broker and what you feel comfortable with. There was a time when it was difficult to find companies prepared to offer margined accounts but nowadays you can get leverage from a high as 1% with some brokerages. This means you could control $100,000 with only $1,000.
Typically the broker will have a minimum account size also known as account margin or initial margin e.g. $10,000. Once you have deposited your money you will then be able to trade. The broker will also stipulate how much they require per position (lot) traded. In the example above for every $1,000 you have you can take a lot of $100,000 so if you have $5,000 they may allow you to trade up to $500,00 of forex.
The minimum security (Margin) for each lot will very from broker to broker. In the example above the broker required a one percent margin. This means that for every $100,000 traded the broker wanted $1,000 as security on the position. Margin call is also something that you will have to be aware of. If for any reason the broker thinks that your position is in danger e.g. you have a position of $100,000 with a margin of one percent ($1,000) and your losses are approaching your margin ($1,000). He will call you and either ask you to deposit more money, or close your position to limit your risk and his risk. If you are going to trade on a margin account it is imperative that you talk with your broker first to find out what their polices are on this type of accounts.
Variation Margin is also very important. Variation margin is the amount of profit or loss your account is showing on open positions. Let's say you have just deposited $10,000 with your broker. You take 5 lots of USD/JPY which is $500,000. To secure this the broker needs $5,000 (1%). The trade goes bad and your losses equal $5001, your broker may do a margin call. The reason he may do a margin call is that even though you still have $4,999 in your account the broker needs that as security and allowing you to use it could endanger yourself and him. Another way to look at it is this, if you have an account of $10,000 and you have a 1 lot ($100,000) position. That's $1,000 assuming a (1% margin) is no longer available for you to trade. The money still belongs to you but for the time you are margined the broker needs that as security. Another point of note is that some brokers may require a higher margin at the weekends. This may take the form of 1% margin during the week and if you intend to hold the position over the weekend it may rise to 2% or higher. Also in the example we have used a 1% margin. This is by no means standard. I have seen as high as 0.5% and many between 3%-5% margin. It all depends on your broker.
There have been many discussions on the topic of margin and some argue that too much margin is dangerous. This is a point for the individual concerned. The important thing to remember as with all trading is that you thoroughly understand your brokers policies on the subject and you are comfortable with and understand your risk.
Even though the mighty US dominates many markets most of Spot Forex is still traded through London in Great Britain. So for our next description we shall use London time. Most deals in Forex are done as Spot deals. Spot deals are nearly always due for settlement two business days day later. This is referred to as the value date or delivery date. On that date the counter parties take delivery of the currency they have sold or bought.
In Spot FX the majority of the time the end of the business day is 21:59 (London time). Any positions still open at this time are automatically rolled over to the next business day, which again finishes at 21:59. This is necessary to avoid the actual delivery of the currency. As Spot FX is predominantly speculative most of the time the trades never wish to actually take delivery of the actual currency. They will instruct the brokerage to always rollover their position. Many of the brokers nowadays do this automatically and it will be in their polices and procedures. The act of rolling the currency pair over is known as tom.next which, stands for tomorrow and the next day. Just to go over this again, your broker will automatically rollover your position unless you instruct him that you actually want delivery of the currency. Another point noting is that most leveraged accounts are unable to actual deliver of the currency as there is insufficient capital there to cover the transaction.
Remember that if you are trading on margin, you have in effect got a loan from your broker for the amount you are trading. If you had a 1 lot position you broker has advanced you the $100,000 even though you did not actually have $100,000. The broker will normally charge you the interest differential between the two currencies if you rollover your position. This normally only happens if you have rolled over the position and not if you open and close the position within the same business day.
To calculate the broker's interest he will normally close your position at the end of the business day and again reopen a new position almost simultaneously. You open a 1 lot ($100,000) EUR/USD position on Monday 15th at 11:00 at an exchange rate of 0.9950. During the day the rate fluctuates and at 22:00 the rate is 0.9975. The broker closes your position and reopens a new position with a different value date. The new position was opened at 0.9976 a 1 pip difference. The 1 pip deference reflects the difference in interest rates between the US Dollar and the Euro. In our example your are long Euro and short US Dollar. As the US Dollar in the example has a higher interest rate than the Euro you pay the premium of 1 pip.
Now the good news. If you had the reverse position and you were short Euros and long US Dollars you would gain the interest differential of 1 pip. If the first named currency has an overnight interest rate lower than the second currency then you will pay that interest differential if you bought that currency. If the first named currency has a higher interest rate than the second currency then you will gain the interest differential.
To simplify the above. If you are long (bought) a foreign currency and that currency has a higher overnight interest rate you will gain. If you are short (sold) the currency with a higher overnight interest rate then you will lose the difference.
I would like to emphasis here that although we are going a little in-depth to explain how all this works, your broker will calculate all this for you. The purpose of this forex markt report is just to give you an overview of how the forex market works. It should help your trading if you are also familiar with trading high yield capital markets in addition to FX trading, as they both involved considerable trading risk of loss.