The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, if the stock bought for $50 falls to $25 and the trader paid for the stock in full, the trader will lose 50% of the money. However, if the trader bought on margin, he or she will lose 100% and will still have to pay the interest owed on the loan.
In volatile markets, traders who put up an initial margin payment for a stock or currency position may, from time to time, be required to provide additional cash if the price of the stock falls. Some traders have been shocked to find out that the brokerage firm has the right to sell their securities that were bought on margin – without notification and potentially at a substantial loss to the trader. Thus, if the broker sells the trader’s stock after the price has plummeted, then the trader will lose the chance to recoup the loss if the market regains.
In currency terms, when a trader buys (goes long) or sells (goes short) a currency pair, the value of the currency pair, as an instrument, is initially close to zero. This is because (in the case of a buy) the quote currency is sold to buy an equivalent amount of the base currency. As the market rates fluctuate, the value of the currency pair position held will also fluctuate. Thus, if the rate for the currency pair goes down, the trader’s long position will lose value and become negative. To ensure that the trader can carry the risk in the case a position results in a loss, a broker will typically require sufficient margin to cover those losses.
A SIMPLE EXAMPLE
If a client opens an account with $100 000, with an agreed margin level of 5%, the client will be allowed to trade with 20 times leverage (100 divided by 5) which means that the client needs to maintain 5% of any open position. Hence, the client can have open positions to the value of $2 000 000 ($100 000 divided by 5%). As profit or loses occur, the amount that can be traded varies accordingly. Thus, if the client made a $20 000 profit one day, then he or she could have an open position of $2 400 000 ($100 000 + $20 000 = $120 000 divided by 5%).
RECOGNIZE THE RISKS
Margin accounts can be very risky and are not suitable for everyone. Before opening a margin account, understand that:
- you can lose more money than you have invested;
- you may have to deposit additional cash or securities in your account on short notice to cover market losses;
- you may be forced to sell some or all of your securities when market prices reduce the value of your securities; and
- your brokerage firm may sell some or all of your securities without consulting you to recoup the loan it made to you.
GENERAL MARGIN RULES
In general, brokers will require a margin to be deposited with the firm before trading can begin. Today, margin rates vary from 1% upwards, depending on the currency pair. For example, trading the euro against the dollar can be traded quite readily on just a 1% margin, while taking a position in a more volatile currency pair, like the South African rand against the dollar, could require a margin of 25%.
Obviously, in order to maintain a currency position, there must be sufficient funds to cover any potential loss:
- Initial margin represents the resources required to open a position.
- Variation margin represents the current profit or loss being made on any open positions.
- Maintenance margin is a minimum amount of collateral needed in the account.
Many margin investors are familiar with the ‘routine’ margin call, where the broker asks for additional funds when the equity in the customer’s account declines below certain required levels. Normally, the broker will allow from 2 to 5 days to meet the call. The broker’s calls are usually based upon the value of the account at market close since various securities regulations require an end-of-day valuation of customer accounts.
However, in volatile markets, a broker may calculate the account value at the close and then continue to calculate calls on subsequent days on a real-time basis. When this happens, the investor might experience something similar to the following example with stocks:
Day 1 Close: A customer has 1000 shares of XYZ in the account. The closing price is $60, therefore, the market value of the account is $60 000. If the broker’s equity requirement is 25%, the customer must maintain $15 000 in equity in the account. If the client has an outstanding margin loan against the securities of $50 000, the client’s equity will be $10 000 ($60 000 − $50 000 = $10 000). The broker determines the client should receive a margin call for $5000 ($15 000 − $10 000 = $5000).
Day 2: At some point early in the day there has been a ‘dramatic’ move in the market and the broker contacts the client to inform him that he has x number of days to deposit $5000 in the account. Shortly thereafter, on Day 2, the broker sells the customer out without notice. What happened? In many cases, brokers have computer-generated programs that will issue an alarm (and/or take automatic action) if the equity in a customer’s account further declines.
For example, assume that the value of the XYZ stock in the customer’s account continues to decline during the morning of Day 2 by another $6000 – that is, the shares are now worth only $54 000. The customer still has a loan outstanding to the broker of $50 000, but now the broker only has $54 000 in market value securing that loan. So, based upon the subsequent decline, the broker decided to sell shares of XYZ before they could decline even further in value.
Had the value of the securities stayed at about $60 000, the broker would probably have allowed the customer the stated number of days to meet the margin call. Only because the market continued to decline did the broker exercise its right to take further action and sell out the account.
CONCLUDING REMARKS
Margin-based trading refers to trading in transaction sizes larger than the funds in the account. By leveraging the funds in the account, traders can take better advantage of small movements in the market to build up profits quickly. Conversely, leveraging an account to trade in larger transaction sizes can just as easily work against a trader and magnify losses, essentially putting most of the funds in the account at risk. As trading foreign exchange on margin can be very rewarding, a strict trading discipline should be adhered to.
In order to limit the risks, a trader should continuously monitor the status of the positions against current market prices and should run stop-loss orders for each position open.Astop-loss order specifies that an open position (trade) should be closed automatically when the exchange rate for the currency pair in question reaches the specified threshold. For long positions, the stop-loss rate is always lower than the current market exchange rate, while for short positions, it is always higher.
Source: A Foreign Exchange Primer
