forex leverage
One of the main reasons why so many people are attracted to forex trading compared to other financial instruments is that with forex you can get much higher leverage than with stocks and futures trading. Basically, leverage means borrowing a certain amount of money to invest in something. Forex leverage is a loan provided by the forex broker to the forex retail trader.
Historically, the amount of leverage provided by forex brokers has varied from 50:1 to 700:1. As an example, with a broker margin of 2%, you have to put only $200 as margin to trade $10,000 worth of currencies. In this respect, forex margin and forex leverage are two sides of the same coin so much so that in the trade above you would leverage your margin of $200 by 50 times. In this case the margin-based leverage is 50:1.
In the forex market we monitor currency movements in pips, which is the smallest change in currency prices. For example, when a currency pair like the USD/CHF moves 100 pips from 1.1200 to 1.1300, this represents only a $0.01 move in the USD/CHF exchange rate. This is why currency transactions have to be carried out in large amounts, allowing these small price changes to be translated into measurable profits or losses. However, unlike large financial institutions most retail traders do not have the financial resources to trade currencies in hundreds of thousands of dollars. This explains why leverage has been introduced in the forex market.
Although the ability to earn significant profits by using leverage is substantial, leverage very often works against investors. Let us see why and how this happens. Assume there are two traders namely Y and Z and each one has $5000 into their trading accounts. They also trade with the same forex broker who requires 1% margin deposit. After performing some technical analysis, both of them agree that the USD/CHF has formed a top and a reversal is imminent. Both of them decide to short the USD/CHF at 1.1200.
Trader Y chooses to apply 100 times real leverage on this trade by shorting $500,000 worth of USD/CHF (100 x $5,000) based on his $5,000 trading capital. Because USD/CHF stands at 1.1200, one pip of USD/CHF for one standard lot is worth approximately $8.92, so a one pip move for five standard lots is worth approximately $44.60.Unfortunately instead of falling the USD/CHF swings to 1.1300 and Trader Y loses 100 pips which is equivalent to a loss of $4,460.This loss represents a whopping 89.2% of his trading account!
On the other hand, Trader Z who is a risk averse trader decides to apply only 5 times real leverage on this trade by shorting $25,000 worth of USD/CHF (5 x $5,000) based on his $5,000 trading capital. That $25,000 worth of USD/CHF equals to just one-quarter of 1 standard lot. As USD/CHF rises from 1.1200 to 1.1300, Trader B also loses 100 pips which is here equivalent to a loss of $223. This loss represents a relatively lower 4.46% of his trading account.
It would be now relevant to make the distinction between margin-based leverage and real leverage.In terms of margin-based leverage the broker allowed both traders to trade up to a maximum leverage of 100:1. Given that the broker requires 1% margin, Y has leveraged his margin of $1,000 to $100,000 for each standard lot. With reference to real leverage he has also used a leverage of 100:1 obtained by taking $500,000 divided by $5,000.
If Trader Y had bought only one standard lot (100,000 worth of currencies) he would have only used 20 times real leverage and lost less money. Therefore it is real leverage which is very dangerous.As in the example above, Trader Y has $5000 but trading positions worth $500,000! In contrast Z also has $5000 but is trading only $25,000. As the trade unfolds you see that Trader Y loses 89.2% of his trading capital while Z loses only 4.46%.
Thus if the forex broker is forced to reduce his margin-based leverage from say 100:1 to 50:1, this means that Trader Y will also be forced to reduce his real leverage since he will be able to buy only 2½ standard lots, that is, $250,000 worth of currencies instead of 5 full standard lots worth $500,000 of currencies. This is why on the 30th August 2010, the CFTC has decided to limit forex leverage for major currency pairs to 50:1. This decision by the CFTC has come into effect on 18th of October 2010.
FOREX LEVERAGE LIVE ON MT4