What Is Margin?

Essentially, it's a loan.

You can trade shares on margin as well, but you probably need to take out an official "margin-lending loan" with a bank. They'll give the money for the express purpose of buying shares. And maybe they'll give rules on which shares you're allowed to pick from.

With currency, when you open an account with a forex broker, you are automatically granted this "loan".

What it means is, you can buy a lot more currency than you have actual dollars of your own.

From the example above, it cost US$123,450 to buy 1 contract of EURUSD. Maybe you don't have US$123,450.

But if your forex broker let you trade on a margin of 1:10, it would cost you only $12,345 of your own money to buy that contract.

If your broker let you trade on a margin of 1:100, it would cost you only $1,234.50 of your own money to buy that contract.

Yes, a bit over a thousand dollars of your cash can buy US$123,450 of Euro.
 

What's The Catch?

It's very easy to lose all of your money :-)

Remember how when you buy 1 contract of EURUSD, one pip up makes you US$10, while one pip down costs you US$10?

You spent $1,234.50 to buy that 1 contract of Euro. How's this calculation for you:

$1,234.50 / $10 = 123.45 pips

That's right - if the EURUSD rate dropped by 123.45 (let's say 124) pips, all your money is gone.

I just pulled up a chart of EURUSD and am looking at daily bars. I picked an average-looking one. It opened at 1.2867, and closed at 1.2752 - a drop of 115 pips in one day in an average-looking bar. Your 124 pips could easily be taken out inside a day.
 

Theoretically, You Can Lose More Than 100%

Well, let's say that all you had was $1,234.50, and you purchased the 1 contract of EURUSD at 1.2345 using a margin of 1:100. It used up all of your account balance.

When the rate came down by 123 pips, you now have only $4.50 of account balance left. When it fell the next pip, now you owe $5.50. As the rate continues to fall, you continue to owe more and more. That's the catch with margin lending.
 

I'm Scared Now, Make It Better

About the owing-money-thing, that's actually only theoretically possible - it's not possible practically. If you owed money to your broker, they would have to be able to get that money from you somehow. When banks lend money so you can buy a house, they can take the house off you if you don't make the repayments. But with currency trading, you could be, and probably are, in a completely different part of the world to the broker. They don't want to be in the debt-collecting game. So they will have procedures in place to sell your 1 contract for you, automatically, if your account balance falls to zero (or close to zero).

So, practically, you're only able to lose 100% of your account balance. I'm sure that's a big relief for you :-)

The mistake we made above that made us lose our 100% was that we bought 1 contract when we only had $1,234.50. We should have gone for something a lot smaller, like 1K or 10K units.

Using a stop loss, and by purchasing the correct amount of units, you can ensure that if your stop loss does happen to be taken out, your monetary loss is limited to a particular percentage of your account. 2% is often quoted as a good figure to risk on any one trade. Risking 2% is not risky at all in terms of your trading survival.

I have to conclude then, that currency trading is not that risky, compared to other types of trading. We can limit our risk on a trade to 2% of our balance if we want. But if you're an idiot then sure, you could lose all your money quite quickly. I'm not sure how this any different though to the stock market. Even walking across the road is risky if you do it wrong.

For the exact method to keep your risk to 2% (or whatever percent, which should be decided by you and you alone), you need to keep reading.