Today's Forex brokers provide leverage of scale unimaginable before, up to 200:1 that means $500 can control up to $100,000. Because buying $500 worth of another country's currency isn't enough to generate significant gains. Currency brokers provide their clients a loan to magnify those small price changes into a much bigger one. This is called margin trading, and this may sound like a scam because an amount as little as $500 could be used as a collateral for a $50,000 loan only to be traded with assumptions that the entire amount might be lost. That is not the case here because it is possible, even you and I could do this together.
Suppose you are to speculate on the housing market, but you only have $50,000 saved up. The price of the house you plan to acquire is $500,000, this means you can't participate on that market because you don't have enough money. Fortunately as your friend I decided to loan you out $450,000 to cover the difference, and because were good buddies, it's interest free. I'm giving you a piggy back ride so you would have the buying power to purchase that house and take advantage should the price increased significantly. In other words, I'm giving you leverage to catch that huge increase in value from that house with as little as $50,000 of your own money.
A year later, the house increased in value to $600,000. Looking at this figure, we can see that the house gained 20% or $100,000 in value. If we sell the house now, you would give me that $450,000 loan back and the profit is yours to keep! Doing the math here you gained $100,000 or 200% with just $50,000. We basically magnified that $50,000 so it could muster the capital enough to generate that kind of profit. But behind all these paper gains, you decided to hold on to it and didn't sell.
Another year had passed something terrible happened to the housing market and the value of the house fell to $480,000. We had an agreement that should the house fall further to $460,000 we are selling the house to prevent your money to be chipped away further and also to prevent my money from being hit. Another month passed by and the inevitable happened, the house fell in value to $460,000. Due to that decline, you sold the house and gave back my $450,000. Unfortunately you have a realized loss of $40,000 or 80% of your $50,000 capital. But because we had an agreement to get out of the deal at $460,000, you prevented your entire capital of $50,000 to be completely lost but the damage has been terrible because you are highly leveraged.
It is now clear that controlling
$100,000 with as little as $500 is possible as long as the amount of losses
out of that $100,000 capital is within that $500 range. This acts as your collateral
so the broker is sure that you have the balance to cover the loss and prevent
your account from going negative.
Now lets apply margin trading currencies through a broker in the next few pages.