OTC vs Exchange

If you come across a word called "Futures" then you should know that you are dealing with a regulated exchange.

A broker working as agents for a regulated listed Futures Exchange is forbidden from tampering with Exchange pricing mechanism. Leverage is set by the Exchange and not the broker. Management of credit facilities occurs on two fronts. Exchange provides the leverage and from time to time changes the conditions. A broker is expected to protect own interests if they are extending any credit facility or lending money to trade.

The risk to the broker is primarily customers losing more money than they have in their accounts.

OTC brokers have the choice of becoming a market maker or passing on the trades to a liquidity provider. Market makers take risks and reap rewards by widening margins, using in-house designed derivatives called CFDs (Contracts for Difference) , most of the time not moving with the real instruments prices

The retail brokers that offer fixed spreads, guaranteed fills and simplified and binary 'profit per pip' outcomes are not passing the trades to the real FX market. They are merely using the prices as a basis to allow you to place highly leveraged bets against themselves. You lose they gain, your trades are never exposed to the real FX market of liquidity providers, slippage, risk and variable spreads

So how do regulated brokers that serve professional traders and require a minimum deposit of $50,000 work?

If a customer has 100k and the instrument has a margin requirement of 100K, then the trader will only be able to trade 1 standard lot which is $100,000. But only if the broker allows customers to commit 100% of the funds they have available – the available margin.

Most brokers have a required margin amount of a percentage less than 100% of available margin, and this percentage can vary according to the instrument, the jurisdiction of the regulation and the prevailing market conditions. If a broker has 50% or more even up to 90% threshold it means they will stop a trader that still has 50% (if threshold is 50%) or 10% (if the threshold is 10%) in the account to provide them with a buffer if the worst comes to the worst according to their risk expectation for that instrument.

Brokers protect themselves with a buffer against the possibility of the customer losing over 100% of his margin and then having to chase the customer for more money. So they set their risk software to block trading unless available margin is above 100% of required margin, for example 120% or 110% or 130% according to their own risk models.

This added available percentage over the required margin dictates the trigger to block the trade/order. This vital information can be found by the trader depending upon the broker's trading platform being used.

Metatrader 4 and getting information on margin

In case of Metatrader 4, right clicking the pair in the 'market watch' window and selecting 'specification' and looking at the 'margin percentage' variable.

For example to trade 1 lot of

• USDCHF you would need to have available 3 times the margin requirement for 100,000 units.

• EURUSD you would need to have available 1.2 times the margin requirement for 100,000 units.

This percentage varies for different brokers and different pairs but it is never (exchange rate discounted) 100%. Therefore someone with a 50k balance should never be able to put on 150k position with 3x leverage in a pair with exchange rate of 1. They will be able to do this if the exchange rate between the pair is not 1.

This is key to understanding why some orders are rejected and why we should never ever assume that a ‘standard lot’ of $100,000 or $80,000 is standard for margin for different pairs where the exchange rate is either below or above 1.

Questions relating to margin etc are a topic that is complex and needs careful study and understanding for customers who want to be exact in their position sizing and money management strategies.

Calculating Margin Requirements – a simple calculator

Margin level (%) is calculated as follows: Equity / Margin X 100.

Margin level gives us the available margin. Depending on the pair and the amount in the account a calculation then has to be made that considers;

Required Margin = Trade Size / Leverage * account currency exchange rate (if different from the base currency of the pair traded)

Spread Dynamics

MT4 spreads are based on leading institution price feeds

Spreads on currency pairs available will vary and are generally tightest during liquid times and widest at times of high volatility or uncertainty.

MT4 works on 5 decimal places - EURUSD quote of 1.19813/1.19826, meaning a spread of 1.3 pips.

Standard Lot Sizes and Maximum Order Cap

1 lot volume = 100,000 of the first named currency

So trading 1 lot of EURUSD is to trade €100,000 of USD.

Some brokers cap individual limit orders for risk purposes.

Spread Costs & Calculations

Spread cost = (Spread X Position Size)/10,000*

We can look at the market watch window to see the spread, for example EURUSD spread = 1.3 Position size = 1 lot (100,000 units)

Spread Cost for 1 lot = (1.3 x 100,000) / 10.000 = $13.00

* 10,000 Factor = this is because the spread is measured on the 4th Decimal Point. This value always remains constant.

The spread cost is always calculated in the second name currency (also known as the base currency) of the currency pair quoted. In the example above, the spread cost is quoted in USD. As the spread or position size varies, the spread cost will vary.

Swap Rate and Fee Calculations

The swap fee (or lending fee) is charged for carrying a position overnight. A forex swap is the difference in interest rates between the two currencies of the traded pair. The calculation will depend on whether the position is long or short.

We can find the swap rate for long and short positions by right clicking the pair in market Watch window and selecting ‘Specifications’

The calculation is then as follows;

Swap = (Pip Value * Swap Rate * Number of Nights) / 10

For example to carry 1 lot of EUR/USD (long)

• 1 lot = 100,000

• Pip Value = $10

• Swap Rate = 0.64

• Number of Nights = 1

Swap fee = (10 * 0.64 * 1) / 10 = $0.64

Example of trading EURUSD pair

We will use the Euro versus the US Dollar, EURUSD, as an example of how to trade FX.

First determine the standard lot size for EURUSD.

The standard lot size for EURUSD is 100,000 EUR.

On standard accounts the minimum trade size is 0.10 lots.

0.10 lots x 100,000 EUR = 10,000 EUR

In FX a pip is a unit used to measure a movement in price. One pip of EURUSD is 0.0001.

If you bought EURUSD with a lot size of 0.10 (10,000 EUR) you would have made 1 USD for every pip (0.0001) the price of EURUSD moved up because 10,000 x 0.0001 = 1 USD.

If you sold EURUSD with a lot size of 0.10 (10,000 EUR) you would have made 1 USD for every pip (0.0001) the price of EURUSD moved down because 10,000 x 0.0001 = 1 USD.

If you bought 0.1 lots of EURUSD at a price of 1.0800 and the price moved up 50 pips to 1.0850 you would have made a profit of 50 USD because 10.000 x 0.005 = 50 USD.

If you sold 0.1 lots of EURUSD at a price of 1.1000 and the price moved down 50 pips to 1.0950 you would have made a profit of 50 USD because 10.000 x 0.005 = 50 USD.

Alternatively if the prices in the examples moved in the opposite direction you would have lost the amounts stated.