Forex margin trading at first glance looks like a way of getting something for nothing.

Get it right and you only have to risk a little of your capital.

It is actually a way of using leverage to multiply the buying power of your money. You use a small sum to control a much bigger sum.

The risk is controllable because it is unlikely that the value of a currency, particularly the major traded currencies, will move by more than a relatively mtm small percentage over the time that you make the trade. So if your brokerage account holds a few hundred dollars you can trade on the margin – which is the amount by which you believe the price will fall. Your kind-hearted broker in effect lends you the balance.

You will also encounter trading on margins in stock and futures trading, but you get much more leverage in the foreign exchange market because of the special nature of currencies. You could achieve a leverage factor of anything from 50 to 200 times the size of your account balance, depending of course on the terms you have negotiated with your broker.

This can mean big profits if you get it right, but the whiplash comes comes in if you get it wrong, and you can suffer equally big losses if not. As in life in general, there is no such thing as a free lunch. The more leverage you decide to use or are allowed to use, the riskier your trading.

Have a look at an example.

You decide to trade the British Pound/US dollar pair. The current rate is shown as GBP/USD 1.7100. That means you need you would need $1.71 to buy one British pound. You decide that the dollar is going to rise against the pound, so you sell enough pounds to buy $100,000.

Assuming your broker uses lots of $10,000 each, you would take a position on 10 lots. Then you sit back, relax (well, maybe not relax) and wait for the price to rise.

This time you get it right and within two days the price had moved to GBP/USD 1.6600. The dollar has gone up and the pound is now worth only $1.66. Sell your dollars, buy back into pounds, you are 2.9% richer (less the spread). As 2.9% of $100,000 is $2,900, you’ve made a very good trade.

But if you’re not a banker with a nice end-of-year bonus, you probably don’t have $100,000 spare cash that you can use on the currency exchange market. And this is where the principle of forex margins kicks in.

Because you are buying and selling different currencies at the same time, you only have to worry about any loss that you might make if the dollar falls instead of going up. And of course you would limit that loss by putting a stop loss in place. In this example, you might need only $1,000 in your account to make this $100,000 buy. Your broker will guarantee the balance of $99,000.

In the real world many brokers operate limited risk accounts, which means that the account automatically closes out the trade if the funds in your account are lost. This protects the trader because it prevents margin calls i.e., stops you losing you more than you have. A broker with many such accounts could be driven out of business by adverse margin calls – which is why a limited risk forex account prevents that from ever happening. The software provided by your broker, which you use to control your account, will simply not let you lose more than you have in your account.

Using leverage is an absolutely standard practice in currency trading, so standard that you will soon do it without even thinking about it.

But remember the whiplash possibility and think about the risks involved. On the face of it, lower leverage means lower profits – but at least you get to survive the evitable ups and downs of currency trade. Unless you have very deep pockets, it is much more sensible never to go to the maximum forex margin that your broker would allow.

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