The usage of of such a specific tool related mostly to forex market as leverage is an opportunity to increase the trading volume at the expense of credit funds held by a forex broker. As a pledge for this loan, funds are used that are in the account with the trader, called margin.
What is leverage?
Leverage gives traders the possibility to use borrowed funds to purchase an investment tool. When trading on Forex, borrowed funds are provided by a forex broker. The availability of large leverage on Forex allows traders to manage significant amounts in the market, having just a small part of funds coming from their own deposit used to cover margin requirements. To calculate the leverage amount, you need to divide the overall amount of the transaction by the required amount of margin.
The amount of credit funds available to the forex trader is estimated by the margin requirements of the specific broker. Margin requirements are mostly expressed as a percentage, and leverage is written as a ratio. For instance, the margin requirements of a broker are 2%. This means that to open a position, the amount of the client’s available funds must be at least 2% of the total transaction amount. In this case, the leverage is 1:50. The use of 1:50 leverage lets the trader to operate on the market $ 50,000, having only $ 1,000 in his trading account. For such a leverage, a 2% movement of the trading instrument on the market will either result in total loss of funds or double the account.
Types of leverage
Leverage varies by country. For instance, in the US stock market, the margin level is usually 50%, that is, 1: 2 leverage is used. In futures markets, borrowed funds are used much more often - it depends on the the type of the contract, leverage can reach values of 1:25 and 1:30. Leverage for the Forex market is 1:50 in the US and up to 1: 400 in other countries.
The availability of borrowed assets and the low minimum requirements for the initial deposit have made the Forex market accessible to private traders. Nevertheless, the redundant usage of credit is one of the key reasons for the emptying of traders' deposits.
The danger of using large leverage is recognized by US regulators, which have established certain restrictions. That was why the US Commodity Futures Trading Commission (CFTC) announced the final rules of trading on the Forex market, limiting leverage for individual traders to 1:50 for major currency pairs and 1:20 for the other currency crosses.
Margin trading does not always carry additional risks. If a trader has a sufficient amount of his own funds, the usage of such a tool as leverage will not necessarily affect his profits and losses. It is necessary first of all to take into account not the size of the leverage provided by the broker, but the percentage of own funds used in trading, that is, the actual leverage.
Forex margin trading example
Let's suppose we use a leverage of 1:100. In this case, in order to trade a usual lot of $100,000, we need to have only $1000 on our trading account. If a trader buya 1 standard lot of USD/CAD currency pair at 1.0310, after which the value of this pair will increase by 1% (103 points) to 1.0413, the balance of our account will double. On the contrary, a decrease of 1% under the same conditions is going to result in a 100% loss. Now, suppose the leverage is 1:50. In this case, we need to have $ 2000 on the account to trade 1 standard lot (2% of $ 100,000). If a trader buys 1 standard lot of USD/CAD at 1.0310, and the cost of this pair will increase by 1% to 1.0413, the increase in funds on our account will be 50%. In turn, reducing the value of a currency pair by 1% under the same conditions will result in a 50% loss of capital.
The movement of the value of the currency pair by 1% is quite common and can occur in a question of minutes, foremost at the time of the serious economic news publication. As a result, the usage of a high leverage in only a couple of losing trades can result in a complete loss of capital. Surely, it is tempting to get 50% or 100% profit per trade, but the chances of success over a extensive period of time using a high leverage are small. Successful experienced forex traders often make several losing trades in a row, but can still continue to trade through the proper use of borrowed funds. Consider another case. Suppose the leverage is 1:5. In this event, the margin requirements for trading operations with a standard lot of $ 100,000 are $20,000. If the transaction is unsuccessful, and the currency pair goes to 1% in the opposite direction to the transaction, the losses of the trader will be constrained to just 5%.
Fortunately, many brokers offer micro lot trading, which allows traders to use 1: 5 leverage on small accounts. Micro lot is a contract for 1000 units of the main currency. Micro lots are an excellent tool for novice traders and for traders with a limited amount of funds.
When opening a transaction, the broker tracks the residual value of assets (amount of funds) in their customer's account. In case when the market moves in the direction opposite to the open position, and the value of the amount of funds falls below the minimum margin level, the trader receives a margin call. In this case, it is necessary to replenish the account balance, otherwise open positions can be forcibly closed by the broker to prevent further losses.
Leverage and cash management (money management)
The use of large leverage is fundamentally contrary to the principles of money management when trading Forex. The main generally accepted principle of money management is the use of small leverage and stops so that the risk per transaction does not exceed 1-2% of the total amount held by the trader.
When trading in the Forex market, traders track price movements in points, that is, in hundredths or ten thousandths of the value of a currency pair (depending on the pair). However, price movements of several points are negligible in percentage terms. For example, if the GBP/USD pair rises by 100 points from 1.9500 to 1.9600, in fact, the rate changes by only 1 cent.
It is for this reason that it is necessary to use leverage to acquire large volumes of currency pairs and to obtain any significant profit. If a trader operates $ 100,000, a move of 100 points will bring him substantial profits or losses. Forex trading gives the trader the possibility to use the actual leverage corresponding to his trading style, nature and money management rules.
The use of leverage proportionally increases not only potential profits, but also losses. The greater the percentage of equity capital that a trader uses in trading, the higher the risk taken. It should be noted that the main role is played by the actual leverage, and not by the leverage offered by the broker.
According to the data of the largest brokerage firms, most private traders lose money when trading on Forex. The main reason for the failure of individual traders is the excessive use of funds their borrow from the forex brokers. Nevertheless, the use of leverage provides the trader with freedom and allows efficient use of existing capital. It is the availability of borrowed funds, as well as the absence of commissions and low spreads made the Forex market accessible to private traders.
Using the minimum actual leverage, the trader achieves comfortable terms of trade due to the possibility of installing more distant but reasonable stops, allowing to reduce potential losses. The usage of a large leverage can destroy the trader’s account balance in the case of an unfavorable market situation due to large percentage losses. It must be remembered that the trader himself chooses a leverage in accordance with their needs. Goals must be reasonable and you should not plan to make a fortune by the end of the month or year through the use of a large leverage.
Author: Kate Solano, Forex-Ratings.com