Forex Trading Course: Chapter 7: Leverage, Margin Trading, Rollover and Type of Orders

Ok, if you are feeling tired by now, too much material, etc. take a rest; you are going to need it in this lesson.

Margin Trading

In contrast to other financial markets where you require the full deposit of the amount traded, in the Forex market you only require a margin deposit. The rest of the amount will be granted by your broker (you will borrow it from your broker).

The leverage could go as high as 400:1 depending on your risk profile and the broker chosen. 400:1 means that you will only need 1/400 in balance to open one position (plus the floating losses). Under this scheme, you only need .25% of the total amount traded.

For example, if you were to trade one standard lot using 400:1 (which equals 100,000 units of the base currency) you would only need $250 ($100,000/400 = $250) for indirect currency pairs [USD quoted as the base currency].

But be careful, HIGH LEVERAGE CAN LEAD TO SUBSTANTIAL LOSSES AS WELL AS SUBSTANTIAL PROFITS. We will get in to detail later on.

LEVERAGE COMPARISON

[Table 3]

There are two things to be considered about margin trading:

1 – Margin trading allows us to keep our risk capital at the minimum since a small amount of money is used to conduct a bigger transaction.

2 – The greater the leverage used, the more risk capital you have at risk, and this takes us to the next concept…

Margin Call

A margin call is the traders’ worst enemy. Unfortunately, this happens to too many traders, some because the use of poor money management techniques (or no usage at all) and some others because they are not even aware of it.

A margin call arises when the balance of the account falls below the maintenance margin (capital required to open one position, for example $250 when using 400:1 or $1,000 when using 100:1 on one standard lot). See the above table.

In a margin call your broker sells off (or buys back in the case of short positions) all your trades.

How so? Let’s dig in a little deeper and try to calculate the maintenance margin…

HOW TO CALCULATE THE MAINTENANCE MARGIN

Again, most brokers calculate this value automatically but it is good to know how this number is calculated.

A trader goes long EUR/USD at 1.2318 on one standard lot. He is using 100:1 or 1% of margin.

He bought 100,000 Euros at 123,180 USD, so the maintenance margin in USD is 1231.80 USD (123,180 x 1%).

If this trader had used 200:1 or 0.5%, the margin would be at 615.9 USD (123,180 x 0.5%)

For direct currencies (or currency pairs where the USD is the base currency) this calculation is simpler:

Since the transaction is in USD, we only need to obtain its percentage in the following way:

If we go long USD/CHF on one standard lot at 1.1445, we are using 100:1

We bought 100,000 USD and paid 114,450 CHF for them, so the maintenance margin in USD is US$1,000 (100,000 x 1%).

LET’S TAKE A CONCRETE EXAMPLE ON A MARGIN CALL:

One trader has opened an account to trade the Forex market. She has made an initial deposit of US$4,000 to her trading account. The next morning she decides to go long EUR (EUR/USD) at 1.2318 on two standard lots (the position equals to US$246,360 = 2 x US$123,180).

She is using 100:1, so the maintenance margin would be US$2,463.6 (US$246,360/100=US$2,463.6).

The next morning, as she wakes up and opens up the charts, dang!!! The EUR has fallen like a rock. When she opens her trading platform, the balance is at US$2,463.60. The adverse price action got her margin called.

When she entered the trade with two standard lots, the maintenance margin raised at US$2,463.60; she only had left the other $1,536 to support her losses. A 100 pip movement on the EUR in two standard lots accounts for US$2,000. That night, the EUR fell 113 pips, and all positions were closed by the broker.

This illustrates the perils as well as the advantages of high leverage!

Rollover

icalThe Forex market is traded on a 2-day business value date. A new value date usually happens after 17:00 EST. So the rollover occurs when the settlement of one trade is rolled forward to the next value date (position or transaction is held overnight), with the cost of the interest rate differential between the two currencies.

For instance, if a trader opens one position on Monday and holds it until Tuesday, the value date will be Thursday.

Triple Rollover

However, if one trader opens a position on Wednesday and holds it until Thursday, the value date would of be Saturday, but since there are no markets on Saturday, the position is rolled forward to Monday. Gaining or paying three times the interest rate, this is called triple roll over.

PAYING AND GAINING INTEREST

[Table 4]

EXAMPLE ON ROLLOVER

A trader goes long USD/JPY at 111.50 (two standard lots, position opened before 17:00 EST). The position is closed the next day.

If Interest rates are:

US – 3.5%

Japan – 0.15%

Rollover calculated in USD

US$200,000[(.035-.0015)/360] = US$18.61

We use US$200,000 because we traded 2 contracts: 100,000 x 2 = 200,000

360 because the interest rate shown is paid over a daily basis. Since our trader only kept the position one day, we have to divide it by 360 (financial transactions are rounded off to 360 days per year).

Rollover calculated in JPY

US$100,000 = 11,150,000 JPY per lot; 11,150,000 x 2 lots = 22,300,000

360 because the interest rate shown is paid over a daily basis. Since our trader only kept the position one day, we have to divide it by 360 (financial transactions are rounded off to 360 days per year).

Interest rates by currency pairs 

[Table 5]

Orders

There are several ways in which a trader can get in and out the market. Different approaches (or trading strategies) require different ways to get in and out the market.

Entry Orders

MARKET ORDER

– Is an order to buy or sell a currency pair at the current market price. For instance, if the EUR/USD quote is 1.2538/41, using a market order will get you long at 1.2541 or short at 1.2538.

LIMIT ORDER

– This order allows us to get in the market below the current price (if we intend to go long), or above the market price (if we intend to go short.) This kind of market order is commonly used for a range bound strategy or by retracement traders.

Range-bound strategies: Buy at the bottom and sell at the top of a given price channel.

Retracement strategy: Waiting for a pull back (when trying to get long) or for a rally (when trying to get short) before entering the market.

STOP ENTRY ORDER

– A stop entry order gets you in the market above the current price if you are trying to buy, or below the current price if you intent to sell. This kind of order is commonly used by breakout traders.

Breakout strategy: Waiting for the market to reach new highs/lows or break an important level before entering a trade.

Exit Orders

LIMIT ORDER

A limit order (or take profit order) specifies at what rate you will exit the market to take profits. If a trader is long, the limit order must be above the entry price. If the trader is short, the limit order must be below his/her entry level.

STOP ORDER

A stop order (or stop loss order) specifies the maximum loss you are willing to take on any given trade in terms of pips. If you are long, the stop loss order must be below the entry level; on the other hand, if you are short, the stop loss order must be above the current price.

Duration of Orders

GTC (Good till cancelled)

This order remains active (“good”) until reached (filled) by the market action or cancelled by the trader.

GTN (Good till N, where “N” is a time period such as 1 hour, 1 day, 1 week, etc.)

Some brokers allow you to define how much time an order can be active until cancelled.

This order remains active (“good”) until reached (filled) by the market action or until the end of the defined time period (1 hour, 1 day, etc).

OCO (Order cancels the other)

An OCO order is a combination of two limit and/or stop orders. One order is placed below the market action and the other is place above the market action (doesn’t matter whether they are buy or sell orders), when the market fills one order the other gets cancelled.