There are several solutions to apply leverage through which it is possible to increase the actual purchasing power of your investment, and Forex margin trading is one of these. This method basically permits you to 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 why is 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 could be encountered in futures or trading as well. However, as a result of particularities of the exchange market, your leverage will be far greater when coping with currencies. You can control around around 200 times your actual balance – of course, according to the terms imposed by your broker. Needless to say that this may let you turn big profits, nevertheless, you are also risking more. As a rule of the thumb, the risk factor increases as you use 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 one pound sterling). You’re expecting the relative value of the U.S. dollar to go up, and buy $100,000. A few days later, the going rate is GBP/USD 1.66 – the pound sterling has dropped, and one pound is now worth only $1.66. In the event that you were to trade your dollars back for pounds, you would obtain 2.9% of one’s investment as profit (less the spread); that is, a $2,900 benefit from the transaction.
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In reality, it is unlikely that you are trading six digit amounts – many people simply cannot afford to trade on this scale. Which is where we can utilize the principle behind Forex margin trading. You only need to supply the amount which may cover the losses if the dollar would have dropped instead of rising in the last 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 deal with limited risk amounts – which means that they handle accounts which automatically stop the trades in case you have lost your funds, effectively preventing the trader from losing a lot more than they will have through disastrous margin calls.
This Forex margin trading method of using leverage is very common in currency trading nowadays. It’s very likely that you will do it soon without so much as a single thought about it – however, it is best to take into account the high risks associated with a lot of leverage, and it is recommended that you never use the maximum margin allowed by your broker.