Using leverage in the Forex market
The use of leverage is an opportunity to increase the volume of investments at the expense of credit funds borrowed from a broker. As collateral for this loan, the funds in the account with the trader, called the margin, are used.
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 is expressed as a ratio. For example, the broker’s margin requirements are 2%. This means that to open a position, the client’s available funds must be at least 2% of the total transaction amount. In this case, the leverage is 1:50. Using a leverage of 1:50 allows a trader to operate on the market with $ 50,000 with only $ 1,000 in his account. For such a leverage, a 2% movement of a trading instrument in the market will result in either a complete loss of funds or a doubling of the account.
Varieties of leverage
Leverage varies by country. For example, in the US stock market, the margin level is usually 50%, that is, the leverage is 1: 2. In the futures markets, borrowed funds are used much more actively – depending on the contract, the 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.
Leverage on Forex
The availability of leveraged funds and the low minimum initial deposit requirements have made the Forex market accessible to private traders. However, overuse of credit funds is one of the main reasons traders’ accounts empty.
Read more about using leverage in the article Leverage in Forex is a double-edged sword
The dangers of using high leverage have been recognized by US regulators with specific restrictions. In August 2010, the US Commodity Futures Trading Commission (CFTC) released the final rules for Forex trading, limiting leverage for private traders to 1:50 for major currency pairs and 1:20 for all other currency pairs.
As of 2013, other countries still use leverage of 1: 400 and higher.
Example of margin trading on Forex
Let’s say we are using a leverage of 1: 100. In this case, to trade with a standard lot of $ 100,000, we need to have only $ 1,000 in our trading account. If we buy 1 standard lot of USD / CAD at 1.0310, after which the value of this currency pair will increase by 1% (103 points) to 1.0413, our account balance will double. On the other hand, a 1% decrease under the same conditions would result in a 100% loss. Now, let’s say the leverage is 1:50. In this case, we need to have $ 2,000 in our account to trade 1 standard lot (2% of $ 100,000). If we buy 1 standard lot of USD / CAD at 1.0310, and the value of this currency pair rises by 1% to 1.0413, the growth of funds on our account will be 50%. In turn, a decrease in the value of a currency pair by 1% under the same conditions will lead to 50% capital losses.
A 1% movement in the value of a currency pair is quite common and can occur in a matter of minutes, especially at the time of publication of serious economic data. As a result, when using large leverage, only 1-2 losing trades can lead to a complete loss of capital. Of course, it is tempting to get 50% or 100% of the profit in one trade, however, the chances of success over the long term using high leverage are slim. Successful professional traders often make several losing trades in a row, but they can still continue trading through the correct use of borrowed funds. Let’s consider one more case. Let’s say the leverage is 1: 5. In this case, the margin requirements for trading with a standard lot of $ 100,000 are $ 20,000. If the trade is unsuccessful and the currency pair moves 1% in the opposite direction of the trade, the trader’s losses will be limited to only 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 base currency. Micro lots are a great tool for novice traders and for traders with limited capital.
Margin Call (margin requirement)
When opening a deal, the broker monitors the residual value of assets (amount of funds) on the trader’s account. If the market moves against an open position and the value of the equity 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.
Using credit shoulder and control monetary means (mani–management)
The use of large leverage is fundamentally contrary to the principles of money management when trading in Forex. The main generally accepted principle of money management is the use of small leverage and stops in such a way that the risk per trade does not exceed 1-2% of the total amount on the trader’s account.
According to the largest brokerage firms, most private traders lose money when trading in Forex. The main (if not the main) reason for the failure of private traders is the overuse of borrowed funds. However, leverage provides the trader with the freedom and capital to use effectively. It was the availability of borrowed funds, as well as the absence of commissions and low spreads that made the Forex market accessible to private traders.