Foreign exchange margin trading is a method of using leverage to amplify the purchasing power of your account equity. Leverage basically means using a small sum to control a much larger sum. This is attainable because it is improbable that the rate of a currency will fluctuate by more than a few percentage points within a short time. So you may place 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 commodities trading, but due to the special nature of currencies, you may get 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 produce significant returns if you are successful, 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 foreign exchange market is shown as GBP/USD 1.7100. So to purchase one British pound you would need $1.71. If you anticipated the value of the dollar to climb against the pound you can 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 a fantastic trade.
But most traders do not have $100,000 spare cash that we can use to trade on the forex 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 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 transaction. 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 impossible. The broker's platform that you use to control your account will not let you lose more than your margin equity.
Using leverage in this way is so common 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 keep in mind the fact, that not all forex signals are winners, so don't bet too much on any single position.
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