There are a number of Forex brokers that pay interest on the balance of funds on a client’s trading account, otherwise known as the margin. The rates, of course, vary between brokers and depend on what is currently unused; in other words, the amount not being used as margin for open trades. Are there any benefits to using this type of broker? And how does it work? Let’s see if we can explain.
What is a margin?
In Forex trading, the margin refers to a trader’s leverage. In other words, it is a form of borrowing. A trader puts up a good-faith deposit as collateral in order to open a position. To look at it another way, it is a portion of your account equity that is set aside and allocated as a margin deposit. The broker uses the margin to maintain a trader’s position, and pools it along with everyone else’s margin deposits to enable them to place trades within the interbank network.
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How does margin trading work in the Forex world?
When a trader uses a margin they will be using it to increase the possibility of a good return. Generally, margin accounts are used by equities traders, but have become very popular for Forex traders. If you are new to the world of Forex trading you will first have to sign up with a Forex broker with interest of margin, and set up an account. By opening this type of account you will be able to borrow money in the short term, which will be equal to your leverage.
What is leverage?
Leverage and margin are terms that often become confused, especially in the beginning. Leverage refers to the practice whereby investors use various financial instruments or borrowed capital (margin) in order to improve the chances of getting a good return on their investment (ROI).
When a trader wants to place a trade they will first have to deposit money into a margin account with a Forex broker offering such a service. There is usually an agreed margin percentage of 1 or 2%. Let’s give an example to try and explain it. Say a trader wants to trade $100,000, and the agreed margin percentage is 1%. In order to continue, the trader will have to make a deposit of $1,000. The broker provides the remaining 99% of the cost.
Brokers don’t charge direct interest on the borrowed money, but if the trader’s position remains open after an agreed delivery date the position will be rolled over, and it’s possible there will be an interest charge. The amount charged will depend on whether the position is long or short, as well as the short-term interest rate of any underlying currencies. The amount of money a trader deposits in their margin account is basically security for the broker. Should the trader’s position get worse, a margin call may be opened by the broker, which will mean the trader either has to deposit more money into the account, or close their position. All of this has to be done in order to minimise the risk.
Will the interest rate charged be expensive?
Much the same as interest charged on a bank loan, interest can be paid or earned on currencies. You all know the premise of Forex trading: One currency is bought, while another is sold. To look at it in another way, the bought currency is owned and the sold currency is borrowed. It is therefore understandable for either the sold currency to incur charges, or the bought currency to earn interest.
Theoretically, all Forex trades are held overnight, and it is this that earns or incurs interest. While Forex markets stay open somewhere in the world 24 hours a day, there is a close of business, which is considered as being 5 pm, North American Eastern time. Provided a trade is entered into and closed before that time, there will be no interest earned or incurred.
How much interest has to be paid? It is based on the prevailing interest rate associated with each individual currency. If a trader is buying USD/GBP, the interest will be based on the rate of interest currently prevailing in the USA.
The fact that trades can be held open for longer than 1 day makes Forex trading even more exciting, and certainly adds another dimension. For some traders this is just what they are looking for. Some even look to carry interest in order to increase their profits.
However, there are certain traders for whom margin of interest is unacceptable, usually for religious reasons. For this type of trader there is the option of opening an Islamic account.
Still feeling a little confused about the whole thing? Then let’s try and explain with an exaggerated example.
How important is a carry trade strategy?
A popular strategy used in Forex trading is the carry trade. An investor buys high-interest currencies and sells currencies with low interest rates. By doing this they can ensure that the rollover interest will enhance their return. Take, for example, the GBP/JPY currency pair, which showed a steady increase in 2005/2006. Carry traders would go long in order to obtain the interest rate differential. Say a standard lot of the GBP/JPY was bought in 2005 and it was decided to sell a year later. Imagine the GBP interest rate was 5.5% and the Japanese interest rate was only 0.5%. After having the trade open for 12 months the trader will have earned £5000. The leverage on their account was 100@1, which meant the margin was £1,000. Therefore the return on the initial investment works out at 500%.
This is just an example, but clearly shows how profitable the process of carry trading can be. It rarely happens to such a degree, and of course the broker will take out their own charges. But it nevertheless shows how this is a way of making a little extra profit if you know what you’re doing, and can find the right Forex broker offering interest of margin.
