Forex Trading - Margin Calls, a Cautionary Tale

Let's examine another sample trade.

Name Bid Ask Change %Change High Low Time

EUR/USD 1.1901 1.1903 -0.0091 -0.76% 1.2024 1.1891 15:26
GBP/USD 1.7439 1.7442 -0.0004 -0.02% 1.7573 1.7410 07:01

The current ask price for EUR/USD is 1.1903. So the 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. Now what?

EUR/USD is now listed at, let's say, 1.1966/68. Since the investor owns euros, but wants to profit in dollars he now sells euros for dollars. Selling yields:

100,000 x $1.1966 = $119,660

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

Not bad for a day's work, taking all of ten minutes. Of course, cockiness is unwise in currency trading, where rapid losses are just as quick to arrive as profits. But let's be optimistic today.

The average investor often doesn't have $100,000 or more to toss around. And one lot would be low in the world of currency trading where $20 million can change hands in the time it takes to make a mouse click. So, that's where margins come in handy.

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

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. Sweet deal!

But here's what can go wrong...

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

Of course, at this stage no one knows how long 'temporary' is, nor whether the price will fall further or rise to your target selling price. Your broker, not knowing your credit worthiness or simply having bills of his own to pay, 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.

Note, this is unlikely to happen on a drop of only three pips (we're just keeping the numbers simple here), but it points to some important lessons.

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 before the broker liquidates. No one likes surprise losses. Not that the others are welcomed, either. At minimum, you should be aware of the margin call policy.

Keep your credit healthy. If you don't have enough capital to trade currency stick to stocks or mutual funds. Provide your broker with good reason to believe your credit is good so he's not inclined to sell you out at the first sign of trouble.

Watch the market. Currency trading requires more diligence than stock or bond investing. Prices move quickly and large sums are involved. Currency prices are sensitive, even more so than other investments, to momentary political events, central bank pronouncements and other news items.

Those events are magnified by the fact that many countries are involved. Currencies trade in pairs, but professional traders are usually thinking of several different pairs at once. They watch euros against dollars and dollars against yen, playing small movements among pairs.

If you can't pay attention, currency trading is not for you. That doesn't mean you should be a day (or hour) trader in currency. That action is for the professional and they often lose money that way as well. They work for large banks and can afford to, temporarily. They have bigger pockets and will make it up tomorrow. But stay aware of your position.

Leverage is a terrific tool for the investor. But, as we've seen, there's no such thing as a free lunch. Knowledge can keep you from getting eaten!