T2W Trading Community

4. Worked examples

4.1 Betting on a rise

Assume that you start with a clean slate and that the current GPB/USD rate is 1.5847/52.

• You expect the pound to appreciate against the US dollar, so you buy a single lot of 100,000 GBP at the offer price of 1.5852 USD.
• The value of the contract is 100,000 X $1.5852 = $158, 520. The broker wants margin of 2.5% in USD, so you must ensure that you deposit at least 2.5% of 158,520 USD = 3,963 USD in your margin account
• GBP/USD duly appreciates to 1.6000/05 and you decide to close out your position by selling your sterling for US dollars at the bid rate. Your gain is: -
  100,000 X (1.6000 – 1.5852) USD = 1,480 USD, the equivalent of 10 USD per point
• Your rate of return is 1,480/3,963 = 37.35%, on an exchange rate movement of less than 1%. This illustrates the positive effect of buying on margin.
• Had GBP/USD fallen to 1.5700/75, your loss would have been:-
  100,000 X (1.5852 – 1.5700) USD = 1,520 USD, a return of –38.35%

The lesson is that margin trading magnifies your rate of profit or loss.

4.2 Betting on a fall

You expect sterling to fall from GBP/USD = 1.5847/52 so you decide to sell 1 lot of GBP/USD.

• The value of the contract is 100,000 X 1.5847 USD = 158,470 USD. You have effectively sold 100,000 GBP and bought 158,470 USD.
• Your broker requires 2.5% of 158,470 USD as margin in US dollars, namely 3,961.75 USD in cash• GBP/USD falls to 1.5555/60 and you are sitting on a paper gain of: - 100,000 X (1.5847 – 1.5560 USD) = 2,870 USD
• Your 2,870 USD paper gain is credited to your margin account where you now have 6,831.75 USD. This enables you to maintain open positions worth 273,270 USD• However, GBP/USD starts to rise. When it reaches 1.6000/05, you are sitting on a paper loss of: -
  100,000 X (1.6005 – 1.5847) USD = 1,580 USD.
• Your margin account is debited by 1,580 USD, taking it down to 2,381.75 USD which is sufficient to support 2.381.75 USD/0.025 = 95,270 USD worth of open positions. Your current exposure, however, is:- 100,000 X 1.6005 USD = 160,050 USD

Your “shortage in equity” is therefore 160,050 USD - 95,270 USD= 64,780. USD

The broker makes a margin call for 2.5% of 64,780 USD = 1,619.50 USD. If you do not
come up with the money tout de suite, the broker will liquidate your position.

• You eventually close out your position at GBP/USD = 1.5720/25. Your gain is:- 100,000 X (1.5847 – 1.5725) USD = 1,220 USD.

Now that you have no more open positions, you can withdraw the full 5,181.75 USD from your trading account in cash. Alternatively you have enough margin to support 207,270 USD worth of positions.

5. Controlling risk

Trading currencies entails risk and, as we have seen, margin trading can greatly magnify both positive and negative returns. Forex trading demands constant vigilance and does not fit in easily with the human condition that requires time out for food, rest, “comfort breaks” and leisure.

Orders that are executed immediately at current rates are known as Market Orders. However, there are a number of automated orders that can be triggered at pre-set price levels and that can be deployed to control the downside and consolidate the upside: -

• Stop loss: An order to close out a position automatically when the bid or offer price touches a given level.

If you have a long position, you may issue a stop loss order below the current exchange rate. If the market price falls through the stop loss trigger price, then the order will be activated and your long position will be closed out automatically.

If you have a short position, then you would set your stop loss above the current price to be activated when the offer price touches the trigger level.

A “trailing stop loss” is one that is adjusted behind a position as it moves into profit. This is a good strategy for locking in gains. By raising the stop loss trigger price as the position becomes increasingly profitable, the trader can ensure that most of the paper gain is realised if the market turns downwards.

The problem with stop orders is that exchange rates may move through the stop loss trigger prices in volatile markets, making stops impossible to execute at the precise limits.

• Take profits order (TPO): The opposite of a stop loss (i.e. a stop gain). The TPO order specifies that a position should be closed out when the current exchange rate crosses a given threshold.

For a short position, the TPO order will be set below the current exchange rate, and vice versa for a long position.

• Limit order: A buy or sell order that is activated when the current exchange rate passes beyond some pre-set threshold price.

A trader may set a “buy” limit order when the exchange rate falls below a pre-set threshold. Alternatively, a “sell” limit order may be given for an exchange rate above a given threshold

Limit orders can be good for a specified period (e.g. a day, a month) or “good till cancelled” (GTC). A good-for-the-day limit order is held open for the balance of the trading day unless it is filled before then. A GTC limit order is held open indefinitely (unless filled) and is only terminated on instructions by the account holder.

• One cancels the other (OCO): A combination of a stop loss and a limit order (or two limit orders) at opposite ends of the spread. When one is triggered, the other is terminated.

For a long position, the stop loss will be set below the market spread and the limit sell order above the market spread. If the base currency rate breaches the limit order threshold then the position will automatically be sold and there is no longer the need for the stop loss which will be cancelled. Alternatively, if the rate falls to the stop loss trigger price, then the position will be closed out and there will be no need for the limit order.

For a short position, the stop loss is set above the market spread and the limit order below. If the exchange rate rises to the stop loss trigger price then the position will be closed out and the limit order will be cancelled. If the exchange rate falls to the limit order trigger price, then the limit order will be activated, the position will be bought back and the stop loss will be cancelled.