The Margining System

One of the most important yet least understood aspects of the margin foreign exchange market is the clearance and settlement of trades. Brokers have the full responsibility for clearing and settlement of all parcels of currency traded.

Margins

The unique aspect about the foreign exchange market is the high gearing or leverage characteristic, with the ability to obtain exposure to a relatively large amount of commodity or asset for a small initial outlay creating a high risk/high reward investment. Therefore, in order to protect the financial security of all participants in the foreign exchange markets the broker conducts a rigid system of margining. There are two types of margins – namely initial margins, which sometimes are called deposits, and variation margins.

The first is the Initial Margin, sometimes called a deposit, which acts as a security for each foreign exchange position opened and is refunded when the foreign exchange position is closed out, providing the client meets all payments. The initial margin generally represents a percentage of the underlying value of the position. For example, if the initial margin required to trade the AUD is 2% (subject to change) which provides exposure to an currency portfolio with a value of AUD$100,000. With every one-point movement a trader is subject to a profit or loss of USD$10 per point before brokerage. The AUD moves on average 50 points in a single day representing a profit or loss of USD$500 per AUD$100,000 before brokerage. Initial margins are governed and set by the broker and vary from time to time according to the volatility of the market in question. This means that an initial margin may change after a position has been opened, requiring a further payment (or refund on request) at that time. They are carefully calculated to cover the maximum expected movement in the market from one day to the next.

The forex broker also requires the client to lodge or receive daily settlement margins known as the Variation Margin. This occurs on a daily basis and reflects the actual profit or loss incurred on an open foreign exchange position. This variation margin involves actual flow of funds between the client and the forex broker. The variation margin ensures that MFA Derivatives will have cash on hand to pay equivalent profit to the client holding an opposite position. If the market fails to recover before my contract matures, this variation margin will not be recovered; it would then become a realised loss.

It is important to provide sufficient capital for both initial margins and variation margins. A common mistake made by inexperienced traders is over-trading and trading with insufficient funds. This must be maintained by the client at all times whilst the position remains open. Should this amount fall due to variation margining, the client must top-up the account. This is known as a margin call. If the client is unable to provide the broker with sufficient funds to cover the initial margin or subsequent variation margins, the broker has the right to close some or all of the open foreign exchange positions.

Initial margins and variation margins must be paid immediately (this is generally taken to mean within 24 hours of the call, although in times of extreme price volatility this may mean as little as one hour). If a client does not pay a margin, the Broker is entitled to close out the client’s position and deduct the resulting realised loss from the initial margin.

Initial margins (unless eroded by losses) are returned when the FX currency position is closed. Margins that become realised losses are not refundable unless there is a favourable change of direction in market prices prior to settlement or closing out of the contract.

Settlement

A foreign exchange position never expires, but is marked to market each day. When closing out a position it can be done in one of two ways:

Physical Delivery

If you intend to take delivery, meaning that you actually want to exchange an equal amount of funds to offset the currency position for which you have been holding, then you would need to advise the broker before the value date of this intention. This option is mainly for corporate firms as most traders only use forex trading for speculation. Under this agreement the seller agrees to deliver to the buyer, and the buyer agrees to take delivery of the quantity of the currency described in the contract. If actual delivery is intended, it is essential to first check with the adviser. A parcel may be bought and sold many times before the delivery date as businesses attempt to manage their risk. This is what accounts for the large volume traded, though relatively little is delivered, since the basic purpose of a foreign exchange contract is to provide price-change protection.

Cash settlement

The other kind is where you take an opposite position in the currency concerned to the one originally opened. Taking an opposite position for the same amount in the same currency will realise a profit or loss, which will then be credited to or debited from your account. This is forex trading!

Profit / Loss = number of points made x points value = 200 x USD$10 = USD$2,000