Forex margin trading is a way of applying leverage to the purchasing power of your money to increase profits. Leverage simply means using a small amount of money to control a much larger sum. This is possible because it is unlikely that the value of a currency will change by more than a certain percentage over a short time. So you can place a few hundred dollars in your brokerage account to trade on margin – the amount you think the price will fall. Your broker will effectively lend you the balance.
Trading on margin is also known in the stock and futures markets, but because of the special nature of currencies, you can apply much more leverage in the Forex market. Depending on the broker’s terms, you may be able to control 50, 100 or even 200 times your account balance.
This can lead to big profits if you are successful, but it could also mean considerable losses if not. Generally, the more leverage you use, the more risky your trading is.
We understand leverage and margins by considering an example.
Imagine that the current rate on the British pound to US dollar Forex market is shown as GBP/USD 1.7100. So to buy one British pound you would need $ 1.71. If you expected the value of the dollar to rise against the pound you might 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 made a profit of 2.9% less the spread. 2.9% of $ 100,000 is $ 2,900, so that would be an excellent trade.
But most of us do not have $ 100,000 extra money that we want to trade on the currency market. So here is where the principle of Forex margin comes into play.
Because you are buying and selling currencies at the same time, your money just has to cover any losses that may occur if the dollar falls instead of rising. And you would put a stop loss in place to minimize losses, so $ 1,000 can be all you need to have in your account to make this $ 100,000 purchase. Your broker guarantees the other $ 99,000.
In fact, many brokers now operate limited risk amounts, and the account will automatically close the deal if whatever funds you have on your account are lost. This prevents the margin calls that could be disastrous for a trader, because they mean that you can lose more than you have. But with a limited risk Forex account that is not a possibility. Broker software that you use to manage your account will not let you lose more than your account balance.
Using leverage in this way is so common in currency trading that you will do it without even thinking about it. Still, it is important to consider the risks. Lower leverage is always safer, and you may never want to go to the maximum Forex margin your broker will allow.
Christopher Shepherd has been actively trading in the foreign exchange markets for the past 15 years. Recently he has been using his experience to write reviews of the best automatic forex software systems. This information as well as a series of informative posts about the forex market can be seen at http://newforexprofitsystems.com.