The rapid development of Forex industry and popularity of Forex trading has been made possible due to several factors. If earlier exchange trading and currency exchange transactions were available only to a small circle of businessmen with large funds, now it is available to almost everyone. Technological progress has played the important role, the spread of the Internet availability, the information revolution and globalization. But the main reason for the availability of foreign exchange trading was the leverage provided by Forex brokers.
The use of leverage is a possibility to increase the volume of investments due to credit funds borrowed from a broker. As collateral for this loan, funds are used that are in the account of the trader, called margin.
The amount of borrowed funds available to the trader is determined by the broker's margin requirements. Margin requirements are usually expressed as a percentage, and leverage as a ratio. For example, the broker's margin requirements are 2%, this means that in order to open a position, the amount of available customer funds must be at least 2% of the total transaction amount. In this case, the leverage is 1:50. Using leverage of 1:50 allows the trader to operate on the market the trading volume of $50000, having only $1000 in his account. For such leverage, a 2% movement of a trading instrument on the market will result in either a complete loss of funds or a doubling of the deposit.
Principles of marginal speculative trading
The concept of margin trading has been known for a long time. On various sections of financial market, commodity and stock exchanges some part of the transactions was always speculative in nature. Exchange speculators bought goods or stocks cheaply in order to sell them later with a profit. A commodity or a stock cannot depreciate to zero, so the speculator risks only the sum of the difference in price. Exchange brokers provided loans to such traders, requiring only a part of the value of the goods as collateral (margin). Thus, the speculator can receive income from the full value of the commodities, having only a part of the money necessary for its purchase.
The same principle is used in contemporary Forex trading. Most of the participants in this market enter into currency exchange transactions necessary to ensure international trade operations and other payments. These operations form exchange rates based on supply and demand. On the change in exchange rates, currency traders seek to earn income. Moreover, this is done not only by private individual traders, but also by banks, institutional investors, various funds and financial companies. And if for a large financial institutions the minimum transaction amount of $100 thousand is not a problem, for most private traders this is quite a lot.
For them, the foreign exchange market becomes accessible using the principle of margin trading. A trader is required to have in his account an amount sufficient to cover the amount of a possible loss - a margin call. This amount is usually determined as a percentage of the contract volume. The standard in the Forex market is 1%, but can change up or down. Forex brokers offering a high leverage require only 0.1-0.5%. In the rules of margin trading, financial leverage is often written as the proportion of the amount of collateral to the volume of the transaction. A margin requirement of 1% is designated as a leverage of 1: 100. In this case, a trader enters into a transaction with a volume of 100 times more than the amount of his deposit.
Advantages and disadvantages of the leverage usage
The use of leverage in the Forex market by private traders increases their opportunities for generating income. According to statistics, the average deposit of a client of Forex brokers is $1000. With such a deposit, a trader can operate with at least one standard lot. This means that 100 points of profit will double the trader’s capital. This is with a leverage of 1:100, and some brokerage companies offer a much larger ratio. A trader can choose any, in accordance with their capabilities, style and trading strategy.
But leverage on Forex is a two-edged sword. Increasing the likelihood of a higher income implies a higher degree of risk. Margin trading can not be considered just a form of earnings. This is a type of business, and any business is always at risk by nature. Lack of information, ignorance of pricing rules, and many other factors can lead to incorrect assessment of the situation and losses. And with the usage of leverage, losses increase many times over.
For professional traders, the amount of leverage does not matter. The newcomer is tempted to use all of his opportunities. By incorrectly calculating the position volume, such a trader runs the risk of losing the whole deposit, since the broker forcibly closes the transaction when the margin volume is insufficient to cover it. Therefore, many major financial regulators limit the allowable leverage ratio. European regulators even require a customer test to understand the risk of margin trading.
Forex brokers are focused on clients who engage in speculative trading. For such operations, a real supply of currency is not always required. Moreover, not all transactions are entered into the interbank market. If, for example, the company's customers bought 40% of the volume of dollars for euros, and sold 60%, then the combined position of 20% is opened at the dealer or market maker. For each transaction, the broker receives payment, the size of which depends on the volume of the position. Payment is set as the difference between the purchase price and the sale (spread) price. For example, some Forex brokers set a minimum spread of 2 points.
With a standard lot of 100,000 currency units, one point will be $10. Providing leverage, the broker enables a trader with a capital of $1000 to open a position in a full lot and immediately receives $20 profit, regardless of the outcome of the transaction. In fact, a brokerage company does not give any credit to its clients. Traders are given the opportunity to control large amounts of capital, using a small part of it. Thus, the profit of the Forex broker increases many times.
Often, a brokerage company does not require the entire amount of capital to execute customer trading orders. As already mentioned, only the aggregate position, which is executed by a prime broker or a market maker also with a leverage, is brought to the interbank market. However, in the interbank market, leverage is much less and ranges from 1:2 to 1:10. In any case, margin trading is a source of profit for Forex brokers.
According to the largest brokerage companies, most private traders lose money when trading on Forex. The main reason for the failure of private traders is the excessive use of borrowed funds. Nevertheless, the use of leverage provides the trader with freedom and allows the efficient use of available capital. It is the availability of borrowed funds, as well as the lack of commissions and low spreads that made the Forex market accessible to private traders.
Author: Kate Solano, Forex-Ratings.com