Forex margin trading allows traders and investors to work with greater volumes of currencies that they actually own themselves by borrowing. If a trader or an investor sees a particular opportunity in the FX markets and wishes to take advantage of this opportunity that other investors and traders potentially do not see, they will want to take advantage of margin trading.
Generally, you are only able to trade what you have, but with margin trading you can trade more than that. If a trader or an investor predicts that they will yield large returns after taking advantage of a particular Forex opportunity (a certain shift in the exchange rates), they will probably be happy to increase the risk of their trade or investment in order to yield these large returns. They can add risk to the trade by borrowing and investing more money into the trade.
Margin can be defined as the amount of money that is required to keep all of your active orders open, in your Forex trading account. So margin trading is simply trading on margin (trading on money that does not belong to your account).
Let’s take a look at an example and demonstrate how margin trading actually works in currency trading. Let’s say that we have one Forex trader with 1,000 USD in their Forex trading account, with a margin capacity of 5% (margin capacity being the minimum percentage of equity that they are allowed to maintain). This will mean that the trader or investor will be able to work with a whole 20,000 USD, being able to borrow 18,000 USD. So, the margin capacity of 5% means that the they will be able to trade up to 20 times more than they actually have in their Forex account. When using this borrowed money, the money will usually come as short-term credit and is generally interest-free. The total transaction of the trade is also used as collateral for this loan – collateral being the borrower’s pledge of specific property to a lender in order to secure the repayment of a loan.
Of course, margin trading adds a huge amount of unnecessary risk to Forex trading and can be an effective way to increase your losses, too. However, it can also be an effective way to increase your profits, if used both effectively and in moderation. You should really consider margin trading, until you have a good amount of Forex trading experience.
Let’s return to the previous example, with the Forex trader who has 1,000 USD in their account. Let’s say they wish to buy 20,000 USD worth of JPY at an exchange rate of JPY 100/USD 1. This would put the trader or investor at JPY 2,000,000. Now, if the broker’s own loan horizon is only 1 month and Japan’s economy takes a quick turn for the worse, JPY will begin to devalue to an exchange rate of JPY 150/USD 1 and they must now pay back the borrowed money (which will equate to 18,000 USD). However, their holdings are only worth the value of 13,333.34 USD (since JPY 2,000,000 / JPY 3,000,000 = 0.666667 and 0.666667 x 20,000 USD = 13,333.34 USD).
This sounds negative, however on the other hand there is also another opportunity to make a lot of money if you flip the situation around. But the example is given simply to address the amount of risk that margin trading actually brings to the table.
In conclusion, margin trading is a way in which Forex traders and investors can maximize and really magnify both their profits and their losses, by exchanging greater volumes of currencies than they actually hold themselves. It presents more opportunities to Forex traders, however these opportunities also come with more risk. In the stock market, stock brokers will usually only provide a 50% margin capacity and they will also provide maintenance margin requirements, for e.g. if a trader or investor’s stock value falls below 30% in equity, the broker will immediately demand payment from them. These maintenance margin requirements are said to be positive for both brokers and traders, because it means that the broker will get their money back and the investor will not be able to accumulate unmanageable amounts of debt.