Forex margin trading is a method of applying leverage to enhance the purchasing power of your trading funds. Leverage actually means using a small sum to control a much larger amount. This is attainable because it is unlikely that the value of a currency will fluctuate by more than a certain percentage points within a short time. So you may deposit a few hundred dollars in your brokerage account to trade on the margin - the amount that you think the price could change. Your broker will in effect lend you the balance.
Trading on margins is also known in equities and futures trading, but due to the special nature of currencies, you may use a lot more leverage in the currency markets. Depending on your broker's terms, you may be able to control 50, 100 or even 200 times your account balance.
This may lead to large returns if you are nimble, but it can also mean big losses if not. All things considered, the more leverage you use, the more risky your trading is.
We can understand leverage and margins if we consider an example.
Assume that the current rate on the British pound to US dollar forex market is shown as GBP/USD 1.7100. So to purchase one British pound you would need $1.71. If you forecasted the price of the dollar to rise against the pound you could decide to sell enough pounds to buy $100,000. If your broker used lots of $10,000 each, this would be 10 lots. Then you would sit back and wait for the price to go up.
A few days later you might find that the price had moved to GBP/USD 1.6600. Sure enough, the dollar has risen and the pound is now worth only $1.66. If you sell your dollars now and buy back into pounds, you will have garnered a profit of 2.9% less the spread. 2.9% of $100,000 is $2,900, so that would be a great trade.
But most traders do not have $100,000 spare cash that we can use to trade on the foreign exchange markets. So here is where the principle of margin trading comes into play.
Since you are buying and selling different currencies at the same time, your own money simply has to cover any loss that you may possibly make if the dollar falls instead of rising. And you would set a stop loss to limit that loss, so $1,000 could be all you needed to have in your account to make this $100,000 deal. Your broker guarantees the other $99,000.
In fact most brokers now operate limited risk amounts where the account will automatically close out the trade if whatever funds you have in your account are lost. This prevents margin calls which can be disastrous for a trader because they mean that you may lose more than you have. But with a forex limited risk account that is not a possibility. The broker's platform that you use to control your account will not let you lose more than your deposited funds.
Using leverage in this way is so widespread in currency trading that you will soon do it without even thinking about it. Still it is important to bear in mind the risks. Lower leverage is always safer and you may never want to go to the maximum forex margin that your broker would allow. You can also reduce your risk by using highly reliable forex signals. There are a lot of forex signal providers available online. But be aware of the fact, that not all forex signals are winners, so don't bet too much on any single position.
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