Using leverage in the Forex market
The use of leverage is an opportunity to increase the volume of investment at the expense of credit funds borrowed from a broker. For this loan, the funds in the trader’s account, called margin, are used as collateral.
The amount of credit funds available to a trader is determined by the broker’s margin requirements. Typically, margin requirements are 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 funds available to the client must be at least 2% of the total amount of the transaction. In this case, the leverage is 1:50. Using leverage of 1:50 allows the trader to operate in the market $50,000, having on his account only $ 1000. For such leverage, 2% movement of the trading instrument in the market will lead to either complete loss of funds or doubling of the account
Varieties of leverage
Leverage varies from country to country. For example, in the U.S. stock market, the margin level is usually 50%, i.e. leverage of 1:2 is used. In the futures markets, borrowed funds are used much more actively – depending on the contract, leverage can reach values of 1:25 and 1:30. Leverage for the Forex market is 1:50 in the USA and up to 1:400 in other countries.
Leverage on Forex
Availability of borrowed funds and low minimum requirements for the initial deposit made the Forex market accessible for private traders. Nevertheless, excessive use of credit funds is one of the main reasons of traders’ accounts depletion.
Read more about using leverage in the article Leverage on Forex Stick about two ends
The risk of large leverage has been recognized by U.S. regulatory authorities, which have imposed certain restrictions. In August 2010, the U.S. Commission on Derivatives Trading (CFTC) announced the final rules of trading on the Forex market, limiting leverage for private traders to 1:50 for major currency pairs and 1:20 for other currency pairs.
As of 2013, the rest of the countries still use leverage of 1:400 and above.
Example of margin trading on Forex
Let’s say we use leverage of 1:100. In this case, to trade a standard lot of $100,000, we need to have only $1000 on your trading account. If we buy 1 standard lot of USD/CAD at 1.0310, after which the value of this currency pair will grow by 1% (103 points) to 1.0413, the balance of our account will double. On the other hand, a decrease of 1% under the same conditions will lead to 100% losses. Now, let’s assume the leverage is 1:50. In this case, we need to have on the account 2000$ to trade 1 standard lot (2% of 100000$). If we buy 1 standard lot of USD/CAD at 1.0310, and the value of this currency pair will grow by 1% to 1.0413, the increase in our account will be 50%. In turn, a 1% decline in the value of the currency pair under the same conditions will lead to a 50% loss of capital.
A 1% movement in the value of the currency pair is quite common and can occur in minutes, especially at the time of publication of serious economic data. As a result, when using large leverage, only 1-2 unprofitable transactions can lead to a complete loss of capital. Of course, it is tempting to get 50% or 100% profit per trade, but the chances of success for a long time with the use of large leverage are small. Successful professional traders often make several unprofitable transactions in a row, but still can continue to trade at the expense of the correct use of borrowed funds. Let’s consider another case. Suppose the leverage is 1:5. In this case, margin requirements for trading operations with a standard lot of $100,000 are $20,000. If the deal is unsuccessful and the currency pair goes 1% in the opposite direction of the deal, the trader’s losses will be limited to only 5%.
Fortunately, many brokers offer micro lots, which allows traders to use 1:5 leverage on small accounts. Micro lot – contract for 1000 units of base currency. Micro lots are a great tool for beginners and for traders with limited capital
Margin call (margin requirement)
When opening a deal, the broker tracks the residual value of assets (amount of funds) on the trader’s account. If the market moves against an open position and 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 may be forcibly closed by the broker to prevent further losses
Usage Leverage and cash management (managements)
The use of large amounts of leverage is fundamentally contrary to the principles of cash management in Forex trading. The main generally accepted principle of cash management is the use of small leverage and stops so that the risk of one transaction does not exceed 1-2% of the total amount in the trader’s account
According to the largest brokerage firms, the majority of private traders lose money when trading Forex. The main (if not the main) reason for the failure of private traders is the excessive use of borrowed funds. However, the use of leverage provides the trader with the freedom to use the available capital effectively. 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.