Margin Trading in Forex
A number of Forex brokers pay interest on the balance of funds that sits in your trading account, otherwise known as your margin. The rate varies from broker to broker and depends on the unused margin, the amount not currently being used as margin for open trades, sat in your account.
Margin trading in the Forex market – How does it work?
Investors using a margin account are essentially borrowing money in order to increase possible returns on an investment. Margin accounts are mostly used by equities traders, but are also becoming very popular for currency traders in the Forex market.
Newcomers to the Forex market will first have to sign up with a Forex broker with interest of margin. When the right one has been found, a margin account has to be set up. This account allows an investor to borrow money in the short-term, from the broker. The borrowed money will be equal to the amount of leverage being taken on.
What is leverage?
Leverage is when an investor uses various financial instruments or borrowed capital (margin) to increase the likelihood of a good return on an investment.
Before placing a trade, a Forex trader will first have to deposit money into the margin account., with one of the many Forex brokers with interest of margin. How much depends on the margin percentage that has been agreed between broker and trader, but is usually either 1 or 2%. Say for example, a trader wants to trade $100,000 and the margin agreed on is 1%. To continue trading, a deposit of $1000 will have to be made. The remaining 99% will be provided by the broker.
There is no direct interest charged on this borrowed money. However, if a trader’s position is not closed before the agreed delivery date it will have to be rolled over, resulting in a possible interest charge. How much depends on whether the trader’s position is long or short, and the short-term interest rate of any underlying currencies.
The money deposited in a margin account is used as security by the broker. Should a trader’s position worsen the broker may open a margin call. This means the trader will either have to deposit more money, or close out their position, in order to minimize risk.
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How much interest will be charged and when
Much like borrowing money from a bank, interest is paid or earned on currencies that are traded. Trading in the Forex market involves one currency being bought, while another currency is sold. Another way to look at it is to think of the bought currency as being owned, and the sold currency as being borrowed. Therefore, much like a bank, the borrowed, or sold currency will incur charges, while the currency being bought, or owned, will earn interest.
In theory, all Forex currency trades are held overnight, and this is what the interest paid or owed is based upon. Close of business is considered to be 5pm, North American Eastern time. Should a trade be entered during the day, and exited before close of business, no interest will be incurred or earned.
The interest paid or charged is based on the prevailing interest rate associated with each currency. If, for example, a trader is buying USD/GBP, the trade earns interest at the rate paid in the USA, and pays interest at the borrowing interest rate in the UK.
Holding trades open for longer than one day makes the interest owed, or paid, an important consideration, and definitely adds another dimension to Forex trading. Some traders actually like this added dimension and look to carry interest for opportunities to profit.
It’s also important for carry interest to be taken into consideration when holding currency pairs overnight. So important, that many traders consider carry trade to be an important part of their strategy.
Carry trade should also be taken into account with regards interest of margin.
An example to help understand the importance of interest on carry trade
In order to explain the importance of carry interest when currency pairs are held overnight we’ll give you an exaggerated example.
Trader A buys a full size AUD/JPY at the beginning of the year. At the time both currencies were of equal value. Let’s give the Australian interest rate at 5.5%, and the Japanese interest rate at a mere 0.5%. Trader A decides to leave the trade open for 12 months, so will have earned $5000 of Australian dollars in interest. Let’s say the leverage on the account was 100:1, the margin required would be $1000 Australian dollars. Making it a return on investment of 500%.
This is a very exaggerated example, and is only meant as an indication of how the process can work. In reality it will not happen this way, as the bank and the broker will have a spread in interest rates. It is not normally possible to borrow money and pay interest at the same rate as when you invest funds. It is usual for the amount of carry paid to be less than expected, and the amount charged may be higher.