I hear that a lot whenever I begin to talk about making money in forex. Inevitably the question comes up because it is hard for people to make sense of exactly what it is they’re getting when they want to make their first forex trade. I’ve taken a little time to write up a few of the most common examples (in this post and in subsequent posts), see if this helps answer some of your questions.
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This is the first concept you must understand. I hear the question, “I don’t understand what I’m buying and selling in forex pairs” and I think at least something has sunk in. Forex trades come in pairs. Whenever you BUY (go long) one currency – say British Pounds, you MUST be going short some other currency (say Euros).
$10,000 capital leveraged 100:1 (initial margin = 1%) would be able to purchase up to $1,000,000 worth (the “nominal amount”) of the AUDJPY cross pair. Your INITIAL margin position is $10,000 (.01 x nominal amount). Maintenance (or maximum) margin is 0.5% (200:1 leverage), meaning your trading position has to maintain at LEAST $5000 equity (0.5% X 1,000,000) in the account in order to continue to hold the position (or else be margin called – discussed later). So how would this be applied to the purchase of the AUDJPY cross pair?
Presuming your broker and account are in USD, you will need to convert any purchases back into USD from the BASE currency in order to determine the margin actually used in a contract (called a lot) purchased. A standard “lot” is 100,000 units of the BASE currency. You will note the base currency as the FIRST noted currency in a pair, usually USD. Reading the notation USDCAD, for example – USD is the BASE currency, CAD is the “counter” currency. USD is not always the BASE currency however, and there is actually a rigid heirachy as to which currency will be the base in any given pair. Trading would be impaired by communication errors were there not some sort of standard heirarchy/quoting convention in place. The heirarchy is:
We’ll look at examples using whole LOTS (of 100,000 units). Many brokers offer mini-LOTS (10,000). Simply reduce the ending figures by a factor of ten to see the numbers in terms of minis.
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So for example if you wanted to go long the USD against the Yen, you would be BUYING the USDJPY cross rate (at the time of this writing, USDJPY is running about 81.00 Yen per USD. You might see this quoted as USDJPY Bid/Ask 81.00 / 81.02. Conversely in our example we want to go LONG 1 AUDJPY contract instead. Given our example account is in USD and the BASE currency of the CROSS rate (AUDJPY) we want to buy is in AUD, then we will have to determine how much margin (in USD) is used per AUD LOT we buy. This is simply done by applying the BROKER’s present margin cross rate for the AUDUSD (for argument’s sake let’s say it’s 0.9800 – today’s approximate AUDUSD rate and 82.35 is the USDJPY). 1 LOT of AUDJPY is equivalent to 100,000 Australian dollars (AUD). In US dollars, that converts to 100,000 x 0.9800 = $98,000
To determine the INITIAL margin then, we multiply the LOT cost (in USD – the account currency) by the initial margin (100:1 leverage = 1% margin) = $98000 x .01 = $980. Presuming we want to commit our entire capital of $10,000 cash to buying AUDJPY lots, we would then be able to purchase a total of 10 LOTs of AUDJPY at a commitment of $9800 of available margin, leaving $200 of free margin ($10,000 initial capital less $9800 committed to the 10 AUDJPY lots). Your EQUITY in the account is $10,000 ($9800 committed capital plus $200 free capital). If we presume AUDJPY is 80.70 (as it is today), then when we buy 10 LOTS of AUDJPY we are now LONG 1 million AUD and SHORT 80.7 million Yen. Note we haven’t SPENT any USD here. $9800 of it is COLLATERAL for our MARGIN purchase, but in reality no USD have changed hands in this transaction: we’ve essentially BORROWED 81 million YEN, and BOUGHT 1 million Aussie dollars.
Here’s where the math starts to get crazy: there are multiple scenarios to consider in a three was currency scenario like this. The ones that will impact your trading profits are: changes in the AUDUSD, changes in AUDJPY, and changes in the USDJPY.
Let’s presume things go well and the AUD appreciates against the Yen, but neither has moved against the USD. Pretend AUDJPY now stands at 81.00. If we were to close the position today, we would SELL 10 LOTS AUDJPY, paying back 1 million AUD and receiving 81 million Yen. The net balance in our account is now +300,000 Yen. In our initial state we said USDJPY was 82.35, and here we’ve said USDJPY has not changed so the USD value of those 300K yen is 300,000 / 82.35 = $3643. Presuming we sold the Yen back into USD we’d now have $13,643 in our CASH account, free to trade again.
What if things did not go so well however? What then? Let’s presume the AUDJPY fell instead of rising (USD remaining unchange vs both). Where might we stand if AUDJPY fell to 80.00?
As before we start by imagining that we were SELLING our 10 LOTS of AUDJPY, only now we SELL 1 million AUD and receive only 80 million JPY in return! We’re STILL SHORT 700K Yen! What would our LOSS be if we liquidated the 10 LOTS and had to pay back those 700K Yen? Simply divide the 700K by the current USDJPY rate (unchanged from our initial position of 82.35) and the loss is $8500! YOWZA that’s a lot of money lost! Would this really happen? In truth the answer is technically most likely no. This is where maintenance margin and “margin calls” come into play. These situations of high losses need to be nipped in the bud before accounts go negative (and hence jeopardizing the trade integrity). Your BROKER establishes a LIMIT as to how LOW your margin can be before they simply liquidate the account (preventing further losses and potentially exposing themselves to covering YOUR bad trades).