- Jan 23, 2012
The Basics of FOREX Margin
Beginning traders often fail to realize that margin isn’t a cost; instead, it is simply a good-faith deposit required by brokerage firms as collateral to ensure the ability to cover losses suffered in speculative trades. In other words, despite sometimes being called a “margin charge,” it isn’t a charge at all. You can look at it similar to the down payment banks (should) require for a mortgage loan to cover any possible drawdowns in the value of the home. If a homeowner is required to provide $20,000 as a down payment to qualify for a loan, the balance goes toward equity in the home to be recouped when the home is later sold (assuming it is sold for a higher price than the loan balance). The down payment, similar to FX margin, isn’t an expense; instead, it is a buffer against the possibility of lower home values and borrower default. FX margin should be looked at in the same manner.
The popularity of FX exploded once retail traders caught wind of the excessive leverage built into the marketplace, and this didn’t take long given the aggressive advertising techniques of the first FOREX brokers on the scene. New regulations put in place by the NFA limit the leverage U.S. brokerage firms can offer to 50 to 1; the original regulatory leverage cap established in 2010 was 100 to 1, but it was quickly restricted even further. In the simplest view, assuming a 50-to-1 leverage ratio, for every Dollar in margin collateral on deposit, a trader can enjoy or suffer from the profits or losses of $50 worth of currency.
Although the NFA limits leverage provided to U.S. FX traders to 50 to 1, some overseas brokerage firms offer much more. In fact, I’ve seen firms offer leverage to the tune of 400 to 1! On the other hand, the NFA does not stipulate the minimum leverage an FX trader can utilize. This might seem obvious, but traders typically overlook its implication.
Although traders might be free to utilize high amounts of leverage, they can always choose not to by executing trades in smaller volume relative to account size. Leverage can be eliminated altogether by simply funding the account with the entire contract value; also known as the nominal value. In most FX currency pairs (currency futures will be slightly different), this is approximately $100,000 per standard contract, $10,000 per mini contract, and $1,000 per micro. It might appear unproductive to eliminate the leverage, but some of the most successful derivatives traders have done it this way. Realistically, I believe the optimal balance to be somewhere in the middle.
For instance, a trader buying or selling a contract valued at $100,000 would need to have $2,000 in a trading account to meet the minimum margin requirement as stated by NFA’s 50 to 1 leverage regulation ($100,000/50, or (1/50) × $100,000). The same trader could reduce her leverage, and thus exposure to risk, by either funding the account with much more than the required $2,000 or simply trading a smaller contract size. As we will later discuss, mini FX contracts can be bought and sold in increments of $10,000; accordingly, this trader could opt to trade $10,000 instead of $100,000 with an account size of $2,000. By doing this, she would adjust her leverage ratio to a more comfortable 5 to 1.
Although more government regulation in the financial markets isn’t always the best remedy, I was a supporter of the NFA’s original leverage cap. 100 to 1 is more than enough for speculators; in my opinion, anything more is the equivalent to the Shards O’ Glass popsicles in the “Truth” ads speaking out against tobacco. Further, I believe aggressive marketing of high leverage is unethical in that it promotes low-probability trading and breeds anguish, for the sake of generating massive brokerage revenue. Unfortunately, higher rates of leverage are easy to sell to novice traders because newcomers tend to look at trading with a glass-half-full mentality; they have a propensity to focus on the positive and block out the negative. I rarely hear a beginning trader ask how to calculate the amount of money he might lose if the market goes from point A to point B. Instead, I’m routinely asked how much one will make if....
It is certainly true that more access to free leverage might translate into faster and larger profits, but the reality of the situation is that it will probably lead to nearly immediately devastating results. In essence, the more leverage a trader uses, the less room for error he is giving himself. When it comes to trading, or anything else in life, the further from perfect you have to be, the better the odds of success you will face.
Unfortunately, nothing in FOREX is simple; despite the leverage ratio being stated and constant, the actual margin charge quoted in U.S. Dollars is not. Simply put, margin rates on each currency pair constantly fluctuate in real time with market prices. This differs greatly from trading in the futures markets, where a stated margin rate is relatively stable and standard.
The exact amount brokerage firms expect to be on deposit to hold positions in the FOREX markets is based on the stated leverage ratio (typically the NFA’s 50 to 1), the notional value of the holdings (total value of the currency contracts traded), and possibly the exchange rate of the greenback. This is because FOREX traders stand to benefit or suffer from price movements based on the entire value of the trade, the notional value, and not the margin on deposit. Once again, this can be compared to the way home owners are exposed to the price risk of their entire property value rather than the down payment and accumulated equity.
Stock traders wishing to trade on leverage, or sell shares short, must first borrow shares from their brokerage firm and pay interest on the loan. Conversely, FOREX traders are buying and selling an agreement to deliver the underlying asset, rather than the asset itself. Therefore, there is no borrowing of currency to initiate a position valued at as much as 50 times the required margin deposit. As mentioned, a FOREX trader is simply required to deposit a down payment on future losses known as margin.
The practice of holding margin, in lieu of the freedom to buy or sell contracts in any order and on leverage, is similar to trading in the futures market but is in stark contrast to the policy of stock brokerage firms. However, in futures it is primarily the exchange that sets margin requirements; the broker plays a secondary role in doing so, and the NFA has yet to establish leverage rules in the futures arena. In Chapter 2, “Making ‘Cents’ of Currency Pairs,” we discuss how FOREX margin is calculated, and in Chapter 6, “What Are Currency Futures?,” we cover the details of margin on futures contracts.
Despite interest-free leverage provided by brokerage firms, FX traders are subject to the interest rate differential between the currencies in any pair held overnight (beyond the NY close). A position will either earn, or incur, interest depending on the money market rates backing the corresponding currencies. This is unique to currency speculation in FOREX and does not apply to currency futures or ETFs. We will revisit this concept in more detail, but it is important that traders are aware of all the risks, rewards, and liabilities that come with trading spot market currencies.