Using A Margin Call

Forex Trading - Margin Calls

Assuming that the current ask price for EUR/USD is 1.1903. An investor buys one euro (EUR) at the rate of 1.1903 dollars per euro. Trading one lot (100,000 units) means the investor pays 100,000 x $1.1903 = $119,030 and obtains 100,000 euros. The investor speculates that the euro is undervalued against the dollar, and turns out to be right. But, for what profit?.

The EUR/USD is later listed at, 1.1966/68. Since the investor owns euros,

but now wants to profit in dollars,  so he now sells euros for dollars. The selling yields:

100,000 x $1.1966 = $119,660

The profit = $119,660 - $119,030 = $630.

That's not bad for a day's work !, in all probably, less than a hour's work. Of course, boldness does pay off, at least sometimes. Just as where, rapid losses can be just as quick to arrive, as profits.

However, the average investor often doesn't have anywhere near $100,000 or more to toss around. Just as one lot would be low in the world of currency trading where $50 million can change hands in the time it takes to make a mouse click.

So, that's where margins come in handy.

Let's suppose that your broker offers a 1% margin. This means that you put up 1%, and your broker loans you the other 99%. Yes, that's actually done, quite commonly. So your margin deposit is equivalent to 1,000 euros. 1% of $119,030 is 0.01 x $119,030 = $1,190.30. The amount you actually had to invest to purchase one lot of euros at $1.1903.

Then, when you sell, your margin is repaid and you receive the full $630, not 1% of $630 or $6.30. Since 1% = 1:100 you are leveraged 100 times over. In other words you receive the full 100 times $6.30 or $630. Whoever thought borrowing money could be so profitable!

So when purchasing 1 standard lot of 100,000 units of euros for $119,030 the investor has to provide only $1,1903 of his own cash. The broker provides the rest. Cool, Real Cool.

But what can go wrong? ...

So you bought euros, speculating that the euro was undervalued against the dollar. So you estimate the price of a euro (in dollars) will rise in the future, from 1.1903 to say 1.1906 and eventually it did.

But before that happens the price falls, temporarily, to 1.1900. It just lost '3 pips'.

Of course, at this stage no one knows how long 'temporary' is, or whether the price will keep falling further, or rise to your targeted selling price. So, your broker, Who may not really know your credit rating, or worthiness, then decides to cut his losses and liquidate your position. So he sells your euros for dollars and declares for you, without your prior knowledge or permission, a loss.

Brokers are entitled to do this, legally and ethically. They make no commission from you - they profit from playing spreads - and they are loaning you large sums of money for, in essence, zero interest.

SO THEN,

Know your broker. You don't have to be lifelong friends - they liquidate one another's positions, too. But once you find a trustworthy and competent broker it's desirable to keep them, rather than hopping to another the first time something isn't done to your satisfaction.

That way, you're more likely to receive a friendly warning call and you can shore up your position just before the broker does liquidate you. At the bare minimum, you should be at least aware of their margin call policy.

Leverage is a terrific tool for the investor.

But, there's no such thing as a free lunch.

Knowledge can keep you from getting eaten!

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