Forex margin trading refers to the practice of using leverage to amplify the purchasing power of cash. In Forex trading, leverage basically means using a small amount of cash to control a much larger amount of cash. Therefore, this is a great money making tool in the Forex market because you can open a trading account with some few hundred dollars and trade on the margin.
It is important to mention that leverage is a double-edged sword; it can work for you or against you. As much as you can gain a lot of cash using leverage, you can equally lose the same. Thus, you should use leverage carefully. If you succumb to the temptation of over-leveraging your account, you may not live to see another day as a Forex trader.
Trading on margins is also practiced in other financial markets such as stocks and futures trading. However, because of the uniqueness of the Forex market, leverage used in currency trading is usually higher. The level of leverage you can get depends on the stipulations of your broker. Most brokers allow their clients to control 100, 200, or even 400 times of their account sizes.
The following example illustrates this idea of leverage and margin trading the Forex market.
If the current price of EUR/USD is 1.2500, then it means that to buy one euro, you will need $1.25. After carrying out analysis, you may project a rise in the value of the dollar against the euro. As such, you may decide to sell enough euros to buy $100,000. And, if your broker used lots of $10,000, this would be 10 lots.
Luckily, if the price of the currency pair goes as you had expected to 1.2200 a few days later, then one euro is now worth only $1.2200. This implies that the value of the dollar has risen against the euro. If you go ahead and sell your dollars now and buy back into euros, you will have made a profit of 2.4%, without considering the spread charges. 2.4% of $100,000 is $2,400, so that could probably send you laughing all the way to the bank.
If you did not have the $100,000 to execute the trade, your broker will in effect lend you the balance. For example, if you had only $2,000, you broker will guarantee you the remaining $98,000. This is how margin works when trading Forex.