There are several solutions to apply leverage through which you can increase the actual purchasing power of your investment, and Forex margin trading is one of these. This method basically lets you control huge amounts of money by using just a small sum. Generally, currency values will not rise or drop over a particular percentage within a set period of time, and this is what makes this method viable. In practice, it is possible to trade on the margin through the use of just a small amount, which may cover the difference between your current price and the possible future lowest value, practically loaning the difference from your own broker.
The idea behind Forex margin trading can be encountered in futures or stock trading as well. However, due to the particularities of the exchange market, your leverage will be far greater when dealing with currencies. You can control up to up to 200 times your actual balance – of course, depending on the terms imposed by your broker. Needless to say that this may let you turn big profits, however you are also risking more. Generally of the thumb, the risk factor increases as you utilize more leverage.
To give you a good example of leverage, think about the following scenario:
The going exchange rate between the pound sterling and the U.S. dollar is GBP/USD 1.71 ($1.71 for just one pound sterling). You are expecting the relative value of the U.S. dollar to go up, and buy $100,000. A couple of days later, the going rate is GBP/USD 1.66 – the pound sterling has dropped, and one pound is currently worth only $1.66. If you were to trade your dollars back for pounds, you would obtain 2.9% of your investment as profit (less the spread); that’s, a $2,900 profit from the transaction.
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In reality, it is unlikely you are trading six digit amounts – most people just can’t afford to trade with this scale. Which is where we can use the principle behind Forex margin trading. You only need to supply the amount which would cover the losses if the dollar would have dropped instead of rising in the previous example – if you have the $2,900 in your account, the broker will guarantee the rest of the $97,100 for the purchase.
Currently, many brokers cope with limited risk amounts – meaning that they handle accounts which automatically stop the trades for those who have lost your funds, effectively avoiding the trader from losing a lot more than they have through disastrous margin calls.
This Forex margin trading approach to using leverage is quite common in forex trading nowadays. It’s very likely that you’ll do it soon without so much as a single thought about it – however, it is best to remember the high risks associated with a lot of leverage, in fact it is recommended that you never use the maximum margin allowed by your broker.