Before the introduction of forex margin it was impossible for the ordinary man to trade the currency market.Today everything has changed.
The breakthrough in currency trading has come from forex margin whereby small retail traders are making the most of the small amount of money they have. Until the late 1990's foreign currency trading was within the reach of only big banks and other large financial institutions.The concept of margin has stemmed from stock and futures trading and is today helping small retail traders around the world to participate in the foreign exchange market.However, a large majority of traders lose because they do not understand how this key concept works.
Forex Margin is the amount of money required by a forex broker from a forex trader to open a trade or position in the foreign exchange market. So if you have the intention to trade $100,000 worth of currencies your forex broker will request a margin of $1000. So here you have multiplied or leveraged your capital by 100 times.
Every forex brokers you will see online use quotes such as GBP/USD where GBP is the base currency and USD the counter currency.. So if we take an example of the GBP/USD trading at 1.5000 then this means that with one pound you will get 1.5000 US Dollars. Therefore if you want to purchase 10,000 pounds this implies that you will have to sell 15,000 USD.Your forex margin in this example will be only $150.You can now understand how with a small amount of money you can trade a much larger amount of currencies.
Let us take a closer look at how trading on margin can be dangerous.
So we have two forex brokers A and B and they have different margin requirements. Broker A offers a margin of 2% while broker B has a margin requirement of only 1%. We assume that the amount of money you have in each of the two trading accounts is $ 5,000. The spot market rate for the GBP/USD is set as in the example above, that is, at 1.5000. Thus if the price of the GBP/USD moves by a pip or 0.0001 you can either win or lose one dollar.Finally we assume that you will "lock in" $300 as margin on each trade.
Given that broker A has a margin requirement of 2% to buy one lot of the GBP/USD you will need to give him $300 (2% x $15000) On the other hand, Broker B has a lower margin requirement of 1% and thus you will be able to buy 2 lots because here you need to put only $150 as margin for one lot. Let us say that you are unlucky and the GBP/USD swings 50 pips to the downside . The consequences of this unfavorable move are clear: with broker A you lose $50 ($1 x 50 x 1 lot) but with broker B you lose $100 ($1 x 50 x 2 lots).
So with broker A you have leveraged your account by 50 times but with broker B you have leveraged your account by 100 times.The main point that you should understand is that though Broker A requires you to put more money as margin you are in fact facing less risk than with Broker B.This has been indeed the basic argument for the recent proposition of the Commodity Futures Trading Commission (CFTC).
On Jan.13 2010 the CFTC proposed to limit leverage in retail forex customer accounts to 10-1. The proposal was part of a larger regulatory overhaul of retail forex by the CFTC, enabled by authority granted to it in the Food, Conservation and Energy Act of 2008, or the Farm Bill. If this proposal is enacted this means that the potential of forex margin will be drastically reduced so much so that small retail traders will have to give more funds to the forex brokers to trade the same amount of currencies.
