A key feature of retail currency trading is the high leverage that is made possible by the low use of equity. What is the percentage that must be kept as margin on the trading account varies? Trading with 100 times equity is common.
- Airbag Agreement: The account can never go below zero
- Effective risk management with stop loss and Co.
Trading with such large financial leverage offers great chances of winning but also harbors the great risk of loss up to total loss or even losses that go beyond the stake and the account balance. Two case studies are intended to illustrate which results are possible in Forex trading.
The case study I: the bullish euro
An investor expects interest rates to rise in the euro area and interest rates to stagnate in the United States. He, therefore, expects the euro to appreciate against the dollar. At the rate of 1.2850 (ask price), he, therefore, opens a long position in EUR / USD. The position size is 200,000 units (euros) and the margin deposited is 2,000 euros.
Due to the current interest rate levels in the USA and the euro area and the broker’s financing spread, the financing costs amount to EUR 12 per day. They will be calculated from the day following the opening of the position.
The investor’s assessment proves to be correct. The euro rose significantly against the dollar and was trading at 1.3270 7 days later (bid price). The investor, therefore, decides to close out the position and sell it entirely. The sale takes place at the price of 1.3270.
As a result, the investor realizes a profit of 6537 euros, from which the financing costs of 72 euros are to be deducted. The total profit is 6465 euros. Based on the stake, this results in a profit of almost 325 percent in just one week.
Case II: Descending Euro
Starting situation :
An investor sees the economic situation in Europe much more favorably than that in the USA and therefore assumes rising interest rates in the euro area at both the short and long term ends. It opens a long position in EUR / USD at an asking price of USD 1.3050. The position size is 300,000 euros and the margin deposited amounts to 3,000 euros.
The investor’s considerations turn out to be wrong. The market is worried about the national debt of some euro members, which covers all economic hopes. Since politics is unable to take decisive action, the euro comes under massive pressure the following week.
The scenario I: Stop Loss
When the position was opened, the investor already decided that at a price of 1.2950, he would completely close the position and thus avoid major losses. Therefore, together with the order, he placed a stop loss at this price level. This is triggered when the price reaches the relevant market level and closes out at 1.2950. Including the financing costs, the loss is around 2400 euros. 80 percent of the effort is lost.
When opening the position, the investor did not take any loss limitation into account and waived a stop loss. During a turbulent course of trade, the euro literally crashes. At the rate of 1.2700, the investor receives a call from his broker asking him to immediately deposit new capital into his account. Not only the margin of 3,000 euros tied up in the position but also all other balances on the trading account have been used up. The negative balance is now around 2000 euros.
Forex Trading: Loss Limitation is Essential to Survival
The two examples illustrate how wide the range of possible results in Forex trading is. The financial lever makes very large profits possible in a very short time, because even small market movements, which almost always take place, lead to large profits. Conversely, there is an extremely high risk of loss, which in the worst case can even lead to the trader’s insolvency.
The “margin call” by the broker in the example above is an exception. As a rule, brokers close out all open positions before a larger negative balance can build up.
Nevertheless, losses that go beyond the application are quite possible. However, many forex brokers offer their customers an airbag agreement that precludes the account from falling below zero.
Margin call: The obligation to make additional payments can be expensive
One of the most important basic rules in Forex trading concerns loss limitation: Traders who work with very large leverage have to carry out active risk and money management. Otherwise, the risk of a quick total loss is very high. Risk and money management includes several components.
In addition to limiting losses and securing profits through special order types such as stop-loss and trailing stops, it is also important to determine the position size properly.