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The Mechanics of Currency Trading 2

mechanicsMargin balances and Liquidations

When you open an online currency trading account, you’ll need to pony up cash as collateral to support the margin requirements established by your broker. That initial margin deposit becomes your opening margin balance and is the basis on which all your subsequent trades are collateralized. Unlike futures markets or margin-based equity trading, online Forex brokerages do not issue margin calls (requests for more collateral to support open positions). Instead, they establish ratios of margin balances to open positions that must be maintained at all times.

Here’s an example to help you understand how required margin ratios work. Say you have an account with a leverage ratio of 100:1 (so $1 of margin in your account can control a $100 position size), but your broker requires a 100% margin ratio, meaning you need to maintain 100% of the required margin at all times. The ratio varies with account size, but a 100% margin requirement is typical for small accounts. That means to have a position size of $10,000; you’d need $100 in your account, because $10,000 divided by the leverage ratio of 100 is $100. If your account’s margin balance falls below the required ratio, your broker probably has the right to close out your positions without any notice to you. If your broker liquidates your position, that usually means your losses are locked in and your margin balance just got smaller.

Be sure you completely understand your broker’s margin requirements and liquidation policies. Requirements may differ depending on account size and whether you’re trading standard lot sizes (100,000 currency units) or mini lot sizes (10,000 currency units). Some brokers’ liquidation policies allow for all positions to be liquidated if you fall below margin requirements. Others close out the biggest losing positions or portions of losing positions until the required ratio is satisfied again. You can find the details in the fine print of the account opening contract that you sign.

Unrealized and Realized Profit and Loss

Most online Forex brokers provide real-time mark-to-market calculations showing your margin balance. Mark-to-market is the calculation that shows your unrealized P&L based on where you could close your open positions in the market at that instant. Depending on your broker’s trading platform, if you’re long, the calculation will typically be based on where you could sell at that moment. If you’re short, the price used will be where you can buy at that moment.

Your margin balance is the sum of your initial margin deposit, your unrealized P&L, and you’re realized P&L. Realized P&L is what you get when you close out a trade position, or a portion of a trade position. If you close out the full position and go flat, whatever you made or lost leaves the unrealized P&L calculation and goes into your margin balance. If you only close a portion of your open positions, only that part of the trade’s P&L is realized and goes into the margin balance. Your unrealized P&L continues to fluctuate based on the remaining open positions, as does your total margin balance. If you’ve got a winning position open, your unrealized P&L is positive and your margin balance increases. If the market is moving against your positions, your unrealized P&L is negative and your margin balance is reduced.

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Calculating Profit and Loss with PIPS

A pip is the smallest increment of price fluctuation in currency prices. PIPS can also be referred to as points; we use the two terms interchangeably. Looking at a few currency pairs helps you get an idea what a pip is. Most currency pairs are quoted using five digits. The placement of the decimal point depends on whether it’s a JPY currency pair, in which case there are two digits behind the decimal point. All others currency pairs have four digits behind the decimal point. In all cases, that last itty-bitty digit is the pip.

Here are some major currency pairs and crosses, with the pip underlined:

  • EUR/USD: 1.2853
  • USD/CHF: 1.2267
  • USD/JPY: 117.23
  • EUR/JPY: 150.65

Focus on the EUR/USD price first. Looking at EUR/USD, if the price moves from 1.2853 to 1.2873, it’s just gone up by 20 pips. If it goes from 1.2853 down to 1.2792, it’s just gone down by 61 pips. Pips provide an easy way to calculate the P&L. To turn that pip movement into a P&L calculation, all you need to know is the size of the position. For a 100,000 EUR/USD position, the 20-pip move equates to $200 (EUR 100,000 × 0.0020 = $200). For a 50,000 EUR/USD position, the 61-point move translates into $305 (EUR 50,000 × 0.0061 = $305).

Whether the amounts are positive or negative depends on whether you were long or short for each move. If you were short for the move higher, that’s a – in front of the $200, if you were long, it’s a +. EUR/USD is easy to calculate, especially for USD-based traders, because the P&L accrues in dollars. If you take USD/CHF, you’ve got another calculation to make before you can make sense of it. That’s because the P&L is going to be denominated in Swiss francs (CHF) because CHF is the counter currency. If USD/CHF drops from 1.2267 to 1.2233 and you’re short USD 100,000 for the move lower, you’ve just caught a 34-pip decline. That’s a profit worth CHF 340 (USD 100,000 × 0.0034 = CHF 340). Yeah but how much is that in real money? To convert it into USD, you need to divide the CHF 340 by the USD/CHF rate. Use the closing rate of the trade (1.2233), because that’s where the market was last, and you get USD 277.94. Even the venerable pip is in the process of being updated as electronic trading continues to advance. Just a couple paragraphs earlier, we tell you that the pip is the smallest increment of currency price fluctuations. Not so fast. The online market is rapidly advancing to decimalizing pips (trading in 1⁄10 pips) and half-pip prices have been the norm in certain currency pairs in the interbank market for many years.

Factoring profit and loss into margin calculations

The good news is that online FX trading platforms calculate the P&L for you automatically, both unrealized while the trade is open and realized when the trade is closed. So why did we just drag you through the math of calculating P&L using pips? Because online brokerages only start calculating your P&L for you after you enter a trade. To structure your trade and manage your risk effectively (How big a position? How much margin to risk?), you’re going to need to calculate your P&L outcomes before you enter the trade. Understanding the P&L implications of a trade strategy you’re considering is critical to maintaining your margin balance and staying in control of your trading.

This simple exercise can help prevent you from costly mistakes, like putting on a trade that’s too large, or putting stop-loss orders beyond prices where your account falls below the margin requirement. At the minimum, you need to calculate the price point at which your position will be liquidated when your margin balance falls below the required ratio.

Understanding Rollovers and Interest Rates

One market convention unique to currencies is rollovers.

A rollover is a transaction where an open position from one value date (settlement date) is rolled over into the next value date. Rollovers represent the intersection of interest-ratemarkets and Forex markets.

Currency is money, after all Rollover rates are based on the difference in interest rates of the two currencies in the pair you’re trading.

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