Foreign exchange margin trading is a method of applying leverage to magnify the purchasing power of your money. Leverage actually means using a small sum to control a much larger sum. This is possible because it is improbable that the rate of a currency will fluctuate by more than a certain percentage points over a short time. So you can deposit a few hundred dollars in your brokerage account to trade on the margin - the amount that you think the price may change. Your broker will in effect permit to borrow you the difference.
Trading on margins is also known in equities and futures trading, but because of the special nature of currencies, you can use a lot more leverage in the forex markets. Depending on your broker's terms, you may be able to trade with 50, 100 or even 200 times your trading capital.
This could lead to massive profits if you are nimble, but it can also mean big losses if not. Generally, the more leverage you use, the riskier your trading is.
We can understand leverage and margins through 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 buy one British pound you would need $1.71. If you expected the price of the dollar to go up 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.
Several days later you might find that the rate 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 earned 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 people do not have $100,000 spare cash that we want to trade on the foreign exchange markets. So here is where the principle of forex margins comes into play.
Since you are buying and selling various currencies at the same time, your own capital simply has to cover any loss that you might make if the dollar falls instead of rising. And you would place a stop loss to limit that loss, so $1,000 might be all you needed to have in your account to make this $100,000 deal. Your broker guarantees the other $99,000.
In fact many brokers now operate limited risk amounts where the account will automatically close out the position if whatever funds you have in your account are lost. This prevents margin calls which can be destructive 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 software that you use to control your account will not let you lose more than your account balance.
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 keep in mind the risks. Lower leverage is always safer and you may never want to go to the highest edge forex margin that your broker would allow. You may also reduce your risk by using highly reliable forex signals. There are numerous forex signal providers available online. But be aware of the fact, that not all forex signals are winners, so don't risk too much on any single trade.
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