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It is easy to get caught up with general misconceptions of leveraged forex trading. Look at the two following statements to see if you really understand how leveraged forex contracts are traded.

"Stop-loss orders can always be executed at the stipulated price."

As leveraged forex contracts are geared investments, both market gains and losses are magnified. Therefore, some investors prefer placing a stop-loss order once a position is opened to protect themselves against incurring losses beyond an acceptable level.

If you buy (long) a leveraged forex contract of a currency pair and then place a stop-loss order immediately thereafter, it means that you place a limit order at a price below the current price level. Conversely, you will set your stop-loss order at a level above the price you sell (short) a contract.

A stop-loss order would become a market order once the order level is reached and will be executed at the next available price. During a steady and continuous market, it is quite likely that your stop-loss order will be executed at the price you set should the price move towards that direction, and eventually hits or passes that order price.

However, there are circumstances under which price gaps will arise. When there are price gaps, a stop-loss order may not be executed at exactly the price you have set because the next available price may have moved beyond your order price. A price gap will most probably occur when there is a discontinuous market after which trading resumes. Although most leveraged forex traders in Hong Kong provide round-the-clock trading services from Monday to Friday, they will normally not do so during weekends and worldwide market holidays. When the traders resume their trading services afterwards, and if the then going market price level has significantly deviated from the previous market close, i.e. there is a price gap, your outstanding stop-loss order may be executed at the prevailing price level instead of your order price.

A price gap may also arise when there is a sudden drastic movement of the exchange rates triggered by significant economic or political events. Under such circumstances, stop-loss orders may also be executed beyond their order prices, causing investors to lose more than what they expected when placing the stop-loss orders.

Although a stop-loss order may reasonably protect you from incurring substantial loss should currency movements go against your open position, you should not take it for granted that your stop-loss order will always be executed at the stipulated price. In other words, you should be prepared for and appreciate the potential risks associated with trading leveraged forex contracts, even if you are disciplined enough to place a stop-loss order after each trade. The risk disclosure statement contained in your account opening documents should have made this abundantly clear.

"Locking a position minimises loss arising from an incorrect view."

Suppose you open a leveraged forex position by going long on a contract of a particular currency pair. If it turns out that your view on the currency movement is incorrect, i.e. the exchange rate of the relevant currency falls, you can simply limit your loss by taking an opposite position, i.e. going short on the same currency contract, to close out your open position.

However, some investors prefer adopting a strategy called "locking position", i.e. instead of going short on a contract to close out the long position, a new, short position is taken up, resulting in two open positions, one long and one short.

Some investors thought that, by locking a position, they would be in a better position to assess the outlook of the relevant currency movement and then decide how to unlock their positions by either closing the long or the short position. Others choose to lock their position because they thought that not realizing floating losses would make a difference.

However, by locking in the trading losses would not help you forecast currency movements. Furthermore, once a position is locked the trading loss would have been incurred and fixed. Any subsequent trading actions would not alter the amount of loss that has been incurred. If you consider that you are on the wrong side of the market trend and it is high time to take the trading loss, it is always advisable to close out rather than to lock your position.

If you lock a position because you do not wish to realize the floating loss, you should note that the floating loss resulting from locking a position is essentially no different from the realised loss, as the same amount of loss will remain regardless of how the exchange rate moves.

Apart from paying separate commissions when closing your simultaneous long and short positions, carrying a locked position in leveraged forex contract would result in an interest outlay. This is caused by the interest spread, which is normally 3% (Note 1), between holding a long position and a short position.

For simplicity, we assume that by holding a long position you will receive interest and you will have to pay interest by holding a short position (indeed, there are market conditions under which both the long and the short positions are subject to interest payment). The interest spread stems from the difference between the borrowing and the lending interest rates of the respective currencies. Given the 3% spread, the interest outlay may be quite significant if you carry your locked positions for a long period of time.

Example:

If you buy (long) a contract in Aussie Dollar against the US Dollar (contract amount: AUD100,000) at 0.6200 (interest rate for long position:1%), and you later sell (short) a new Aussie Dollar contract at 0.6000 (interest rate for short position: -4%), i.e. you lock a position, for one month (30 days), the total interest outlay would be (in HK$):

The interest outlay is calculated as follows:

  • Interest received from holding a long position - Interest paid for holding a short position

Interest received:

  • Contract amount of a foreign currency contract x
  • Exchange rate of buying (longing) the position x
  • Interest rate of holding a long position x
  • No. of contracts x
  • No. of days of holding the position / 365 x 7.8

Interest paid:

  • Contract amount of a foreign currency contract x
  • Exchange rate of selling (shorting) the position x
  • Interest rate of holding a short position x
  • No. of contracts x
  • No. of days of holding the position / 365 x 7.8

Accordingly, your interest receipt and interest payment will respectively be:

  • Interest received: 100,000 x 0.6200 x 1% x 1 x 30 / 365 x 7.8 = HK$397.48
  • Interest paid: 100,000 x 0.6000 x 4% x 1 x 30 / 365 x 7.8 = HK$1,538.63

As a result, your total interest outlay for holding the locked positions in Aussie Dollar against US Dollar will be:

  • HK$397.48 - HK$1,538.63 = - HK$1,141.15

Therefore, you should think twice before entering into a locked position given that considerable costs will be incurred in commissions and interests.

Note 1: Currently, a 3% interest differential is not uncommon in the market.