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Foreign exchange margin trading is a way of using leverage to multiply the purchasing power of your trading capital. Leverage actually means using a small amount to control a much larger sum. This is practicable because it is unlikely that the rate of a currency will change by more than some percentage points within a short time. So you can put a few hundred dollars in your brokerage account to trade on the margin - the amount that you think the rate may change. Your broker will practically lend you the difference.
Trading on margins is also known in stock and commodities trading, but due to the special nature of currencies, you can apply a much higher leverage in the forex markets. Depending on your broker's terms, you could be able to control 50, 100 or even 200 times your trading capital.
This can produce great profits if you are winning, but it can also result in big losses if not. Generally, the higher leverage you use, the more risky your trading is.
We can understand leverage and margins through an example.
Imagine that the current rate on the British pound to US dollar currency market is shown as GBP/USD 1.7100. So to purchase one British pound you would need $1.71. If you hoped for the price of the dollar to move 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 move up.
Some 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 made 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 individuals do not have $100,000 spare cash that we want to trade on the foreign exchange markets. So here is where the essence of forex margins comes into play.
Because you are buying and selling different currencies at the same time, your own capital only has to cover any loss that you would certainly make if the dollar falls instead of rising. And you would use 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.
Actually many brokers now operate limited risk amounts where the system will automatically close out the trade 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 can 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 trading capital.
Using leverage in this way is so popular in forex 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 invariably safer and you may never want to go to the maximum forex margin that your broker would allow. You may also reduce your risk by using highly reliable forex signals. There are many 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 trade.
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