Leverage is the ability to use something small to control something big. It can really "up the stakes" in the trading world and while leverage should always be used with caution, it’s a tool many traders use in order to increase returns.
Indeed, leverage is often viewed as the key to trading success, but how does it work and why is it a go-to for those looking for high rewards? Let’s delve deeper. But remember, whether you’re a newbie or a pro, all forms of trading require careful risk management and intelligent execution.
What exactly is leverage trading?
Put simply, leverage revolves around borrowing funds in order to increase a trading position beyond what would be available from a trader’s cash balance alone. It’s usually given in a fixed amount which can vary from broker to broker. For example, if you opt for a 50:1 leverage it means that for every $1 you have in your account, you can place a trade worth up to $50. So, if you deposited $500, you would be able to trade amounts up to $25,000.
Taking a much larger position in the market can make or break you very quickly which is why leverage is often considered a double edge sword. But when utilised effectively, leverage can be the key to trading success. So, what are the key advantages?
Leverage is all about maximising profits regardless of the instrument being traded. The key role of leverage is to increase your profit from each available transaction by multiplying the stakes. While the same effect could be achieved by investing more capital, many traders can only afford to make small deposits without the help of leverage.
While new traders might prefer to trial low levels of leverage such as 5:1 or 10:1 to get a feel for how it works, others may decide to rachet the ratio up. Let’s look at an example.
A trader has an account with $10,000 cash. They decide to use a leverage of 50:1 which means they can trade up to $500,000. This represents five standard lots in the forex world with a standard lot being 100,000 units of quote currency. The change in price of a currency pair is measured in pips with each one-pip movement in a standard lot receiving a 10-unit charge. The trader purchased five lots costing $50. If the trade goes in favour of the investor by 50 pips, the investor will gain 50 pips x $50 = $2,500. A loss of $2,500 is also possible.
- Mitigating against low volatility
Leverage can help to mitigate against the low volatility which is often associated with markets such as forex. A lack of monetary policy changes and potential policy surprises can minimise general moves in currency, but trading with leverage can help traders to benefit from even the smallest market moves. This is because leverage has the potential to deliver larger profits from smaller transaction sizes.
To conclude, when leverage works for you it can really work for you. That said; it’s essential to have risk management strategies in place to avoid equally large losses.
How the FX industry is moving to non-EU based brokers
The financial landscape in Europe is heavily governed with numerous restrictions telling brokers and traders what they can and can’t do. Forex has been hard-hit by an ESMA leverage clampdown in recent years, but does this explain why the FX industry is moving to non-EU based brokers? And what exactly are the benefits of avoiding the EU’s clutches?
Traders move to non-EU brokers as ESMA bites
For many traders, moving to a non-EU broker has extensive appeal, especially due to the new ESMA regulations introduced back in 2019. In a move to cap leverage across Europe, ESMA introduced very strict new rules which state that:
- Trading on FX Majors now carries a maximum of 30:1
- FX Minors, gold, indices and stock CFDs now come with a leverage maximum of 1:20.
- Crude oil CFDs carry a maximum leverage of 10:1
- Extremely volatile stocks will see leverage capped at a maximum of 5:1
While ESMA has put a focus on trader safety, the new rules make it more difficult than ever for traders to benefit from high leverage and potentially gain from small market moves. At times of low volatility, high leverage is often used in order to maximise gains with just a few pip movements. This can potentially result in breath-taking returns.
Of course, trading comes with risks and intelligent risk management strategies are needed in order to reduce losses. But traders who appreciate making their own calculated decisions are now looking for alternatives outside of the EU.
Essentially, ESMA regulations will weed traders with small capital from the European ecosystem. But as the new rules can’t supress a trader’s need to monitor the market, they will simply move to other jurisdictions where high leverage is still provided.
A way out of the quagmire
Since the introduction of ESMA, the financial landscape has started to change considerably. Not only are traders looking for new alternatives far from EU restrictions, but brokers are also moving offshore and applying for licenses outside of the EU.
Well it enables them to continue offering the services traders are used to including a combination of tight spreads and high levels of leverage. Brokers looking to retain clients and reduce revenue shortfalls are branching outside of the EU and are transferring those looking for flexible leverage options to their non-EU branches in countries such as the Cook Islands, Mauritius, Australia, the Seychelles, Vanuatu and other offshore locations.
Essentially, EU trading is more focussed on big players with large amounts of capital who perhaps don’t need to take advantage of high leverage as those with less capital in their accounts. This is an obvious shift, which is why brokers are moving trade away from EU-based regulations in order to stay afloat. Similarly, traders looking for a way out of the EU quagmire are also driving the FX industry outside of the European Union and this is facilitated by forward-thinking companies that want to maintain service standards.
When researching brokers, it’s essential to think about your goals, risk tolerance, and leverage options as well as the regulations each broker is subjected to.
4xcube is one broker that offers an investor compensation fund to the tune of 20,000 Euros and favourable trading conditions and is a true STP broker.