Leveraged foreign exchange (forex) contract is a "geared" investment. Basically, by opening a leveraged forex contract, you invest in one currency on margin in the expectation that its exchange rate against another currency will rise or fall. Whether you make a profit or suffer a loss depends on the difference between the exchange rates at which you open and close your position.
How are profit and loss calculated?
Leveraged forex is traded on a contract basis. The amount of currency covered by a contract is agreed upon between you and your intermediary. Currently, Euro, Pound Sterling, Japanese Yen, Swiss Franc and Australian Dollar are among the most commonly traded currencies.
Profit and loss of a contract depends on how the exchange rate of the specific currency against the US Dollar (or another relevant base currency) changes after a position is opened. Before the contract is closed out, any profit or loss would only be unrealized and would only be realized upon closing out the contracts. Hence, even if you have unrealized profit today, this may turn into losses tomorrow. The formula (Note 1) for calculating profit and loss is as follows:
Contract amount of a foreign currency contract x (Exchange
rate of closing the position - Exchange rate of opening the
position) x No. of contracts x Exchange rate of US$ against HK$
If you buy an Australian Dollar contract (contract amount: A$100,000) at an exchange rate of 0.6000 (against US$) and square off your position at 0.6200, what will be your total profit (in HK$)?
According to the formula, your profit will be:
100,000 x (0.6200 - 0.6000) x 1 x 7.8 = HK$ 15,600
What is two-way quotation?
Leveraged forex is not traded on an orgainsed exchange. It is a contract between you and your counterparty, normally your intermediary. In response to a request for quotation, an intermediary will quote the bid and ask prices simultaneously. This is called a two-way dealing quotation. You can then decide whether to choose to buy (long) or sell (short) a contract at that price. Such a quotation method helps to ensure that fair prices are being quoted, as the intermediary does not know at the time the quotation is made whether you will place a buy or sell order.
What is initial margin?
When you open a contract, you are required to deposit an initial margin - a small percentage of the contract amount. Currently, the minimum initial margin required for opening a leveraged forex contract is 5% of the contract amount of each contract.
How about maintenance margin?
Maintenance margin refers to the minimum level of net equity that is required to keep a contract open. Major components of net equity include any floating profit, any floating loss, cash deposits, cash withdrawals and the amount carried forward on the account. Floating profit or loss refers to unrealized profit or loss calculated by marking to market a leveraged forex contract. Currently, the minimum maintenance margin level is 3% of the contract amount of each contract.
Suppose you open a leveraged forex contract, and the subsequent price movement is unfavourable to that open contract, the floating loss may cause the net equity to fall below the maintenance level thus giving rise to a margin shortfall. If you are unable to make up the margin shortfall in time, the intermediary may close out the position on your behalf without your consent. Under extreme circumstances, i.e. when the market is very volatile with hefty price fluctuations, you may risk losing more than your initial margin deposit and any subsequent margin deposit put in to keep the contract open.
If your account balance (i.e. net equity) is at $45,000, can you buy a Sterling contract when the exchange rate of Sterling is at 1.8100?
The initial margin (in HK$) for opening a Sterling contract (contract amount: £62,500) is calculated according to the following formula:
- Contract amount of a Sterling contract x No. of contracts x Initial margin level x Exchange rate of Sterling x Exchange rate of US$ against HK$
- i.e. 62,500 x 1 x 5% x 1.8100 x 7.8 = HK$44,118.75
- As the net equity (HK$45,000) is higher than the initial margin (HK$44,118.75), you can buy the Sterling contract.
If, after buying the Sterling contract, the Sterling rate drops to 1.7500, is it necessary for you to make a margin replenishment? If yes, how much must you replenish?
- The maintenance margin (in HK$) for a Sterling contract is calculated according to the following formula:
- Contract amount of a Sterling contract x No. of contracts x Maintenance margin level x Exchange rate of Sterling x Exchange rate of US$ against HK$
- i.e. 62,500 x 1 x 3% x 1.8100 x 7.8 =HK$26,471.25
- Net equity of an account with open position is calculated according to the following formula:
- Account opening balance +/- Floating profit/loss
- Floating profit/loss is calculated according to the following formula:
- Contract amount of a Sterling contract x No. of contracts x (Current exchange rate - Exchange rate of opening the position) x Exchange rate of US$ against HK$
- In the example:
- Opening balance: HK$45,000
- Floating profit/loss: 62,500 x 1 x (1.7500 - 1.8100) x 7.8 = -HK$29,250 (i.e. floating loss)
- Net equity: HK$45,000 - HK$29,250 = HK$15,750
- As the net equity (HK$15,750) is lower than the maintenance margin (HK$26,471.25), you are subject to a margin call and need to make a margin replenishment.
- However, once a margin call is effected, you need to replenish the net equity to at least the initial margin level. Accordingly, you need to replenish a margin deposit of:
- HK$44,118.75 - HK$15,750 = HK$28,368.75
Is leveraged forex suitable for everyone?
As leveraged forex contract is traded on margin, the amount of money you are required to deposit is a small percentage of the value of the forex contract you trade. There is a gearing effect on the trading profit and loss. It follows that the lower the margin amount is used to open a position, the higher will be the gearing. Currently, as the minimum initial margin requirement is 5% of the contract amount of each contract, the maximum gearing is equivalent to 20 times of the minimum initial margin. A relative small movement in exchange rates may result in profit or loss that is high in proportion to the minimum margin requirement. However, investors may choose to reduce or manage the gearing by depositing a higher margin to open a position and maintaining sufficient excess margin on their accounts. By doing so, the potential risk of gearing will be reduced.
As leveraged forex is a geared investment, this type of investment may bring you substantial profits, but also equally, substantial losses, in a short period of time. So this is only suitable for the disciplined investor who can afford the loss should he find himself on the wrong side of a currency movement.
Note 1: All formulas adopted in this article only reflect practices of some firms. Other calculation methodologies are not uncommon.