Typical transaction volume in the interbank trading estimates in millions of US dollars. It is clear that such level is unreachable to a private investor, well, at least, to the vast majority.
Small and medium investors are nowadays able to enter the Forex thanks to dealing or brokerage companies. People from all over the World are accessing the currency market with sums of around 1,000-2,000 US dollars. Dealing companies provide clients with a credit line, a so-called “Dealing lever” or “Leverage”, several times the deposited sum. Deposit required by broker is a security sum, enabling client to purchase and sell amounts 50, 100 and sometimes 500 times greater than the deposit made. The client is exposed to risk of losses whereas deposit serves as a collateral insuring the broker. Such system of work through a dealing (brokerage) company using the leverage provided is called “Margin Trading”.
In other words, the mechanics of Margin Trading is the following: the investor places a margin capital in return of an opportunity to operate a targeted credit (secured on the deposited margin capital) and covers all possible losses which may follow the currency exchange transactions.
In contrast to currency exchange transactions intending actual delivery or exchange of currencies, Forex participants especially those having relatively small available funds are involved in trading on a security collateral. Such trading is called margin or leveraged trading. Each margin trading operation is carried out in two phases: purchase (or sale) of a currency at a current exchange rate and a subsequent sale (or purchase) of the same amount of currency at another (or the same) price. The first step is referred to as a position opening while the second one is a position closing. There is no actual currency delivery taking place when opening a currency exchange position but a fragment of the traderâ€™s security deposit is being held out as a guarantee on possible losses that may incur as a result of the position opening. Once the position is closed the held out fragment is released and the final calculation of the currency exchange outcome is carried out.
In a situation when the value of the Euro against the US dollar is considered to have a growing potential a capitalization on a possible rate increase would be a purchase of Euro for US dollars with a subsequent sale at a higher price once the EURUSD exchange rate has risen. In terms of Forex trading this would be opening a position (buying Euro) and closing a position (selling Euro). Such position until itâ€™s closed is referred to as a long EURUSD position. Exactly the opposite actions may be taken if the currencyâ€™s future prognosis tells us of a possible weakening of the currency against another one. In such situation we would sell the currency and buy it back later on i.e. open a short position and close it once the exchange rate has fallen.
For retail clients Forex market is only accessible via an intermediate entity i.e. a Forex broker which provides a sound communication channel, enables a stable broadcast of live market quotations, immediate interaction in terms of transmission and responses to the traderâ€™s trading orders not to mention processing of the trading account administration tasks. Thanks to such a broad range of online accessible services a trader may operate a trading account without having to be physically present at the dealing office. A fully functional trading station may be installed on almost every device with an Internet connection such as PC, PDA or even mobile phone which brings Forex trading to a wider audience than ever before.
A client and a company conclude an agreement according to which the latter one is obliged to carry out operations on behalf of the client and at its own expenses. Therefore the company runs the risk of losses making such operations (because the client, giving orders, may be wrong in his assumptions about the market movement whether it is upwards or downwards) so the client deposits certain amount of money as a margin capital into his account in a bank. The Margin capital amount is defined by the sum of transactions made by the bank and by credit leverage provided to the client. In case of loss incurred by the Brokerage company as a result of performed operation, investor has financial obligations to the Company at the amount of loss that is covered by the security deposit; in case of profit made by the Company as a result of performed operation, the Company incurs obligations to the investor at the amount of this profit. Received profit is deposited into clients security account.
The order to close an open position given by the client to the Company is required, because the Company operates Its own funds. Otherwise, the Bank can close this long position by a short one itself, in this regard the client may incur losses. The situations when currency rates may change more than by two percent a day are extremely rare in the World market, and it is almost impossible to lose all the margin capital playing reasonably. As the Bank dealer sees that potential losses at adverse market movement may exceed the security deposit, he may close clients position with loss that does not exceed margin amount.
Margin trading is attractive because of its accessibility. Out of any doubt, bonds of the U.S. Federal Reserve – the most reliable and stable, but despite their high cost, they provide a low profitability (in the range of 3-6% per annum) and they are the subject to long-term investments which are highly reliable. Profitability on the stocks is higher, but the amount of dividends directly depends on the success of a particular company and preferences of its shareholders. Purchasing stocks on order to speculation for a rise is recognized more interesting but it requires a practical knowledge and experience. Margin trading is devoid of the above limitations, and 1-3% of transaction amount is enough for operating.