The term “leverage” is a very commonly used term in the financial markets. There is no better example of a market that functions on leverage than in the forex market.
Leverage in forex refers to a process whereby the forex trader can borrow money from the dealer or broker at a certain ratio in order to be able to control larger positions in a currency pair. The concept of leverage in forex came about as a result of the following factors:
- The measure of price movement in the forex markets is extremely small. Rather than talking of movements in terms of units of currency (such as $1 or $10 moves), the movements of one currency to another are actually measured in pips, which is $0.0001 or 10,000th of $1. For brokers offering the more precise 5-digit pricing, this is $0.00001 or 100,000th of $1. With such minute movements, and with most liquid currencies achieving average daily price movements of 100 – 200 pips, the only way to make appreciable amounts of money in forex is to control very large positions.
- Talking about controlling large positions, traders must hold positions that equate to at least $10,000 (mini-lots) or $100,000 worth of a currency. Putting down $100,000 for a single trade is definitely out of the reach of many retail traders.
What was the solution? Provide a means for this group of disadvantaged traders to get access to cheap funding to enable them hold these large positions in the market. Thus the concept of leverage was born.
Under the system of leverage, the trader is expected to put up a collateral in order to get counterpart financing from the broker in order to engage a trade. This is not much different from what obtains in the real world of borrowing money from a financial institution. This collateral the trader is expected to put is called margin. The amount of margin out up by the trader as collateral will depend on the level of leverage the account is set to operate on. Leverage ratios range from 1:10 to as high as 1:500. For a trader using a leverage of 1:500, it means that for every $100,000 trade, the trader is only expected to put up $1,000 as margin collateral. In the US, the Commodities and Futures Trading Commission (CFTC) applied a ceiling on the degree of leverage available to retail forex traders, setting it to 1:50. This ceiling radically increased the level of margin collateral needed by retail forex traders for every trade.
Traders must strive to understand what leverage is and what it means to their trading accounts. Injudicious use of leverage can be likened to borrowing money beyond one’s capacity to pay. Leverage can work in the trader’s favour and against the trader too. The higher the leverage used by the trader, the higher the risk of trade losses. Once the trade heads into loss territory and the capital committed to the trade starts to drop, the trader’s margin is in jeopardy and once the trader’s margin is totally depleted, the broker will automatically close the position to protect the borrowed funds, leaving the trader in the cold.
Using Appropriate Leverage
Using very high amounts of leverage sometimes leads to over trading. Due to the seemingly small demand on the trader’s capital by the use of high leverage, traders tend to open too many positions at a time. When too many positions are open, proper control of trades is lost and the tendency to sustain far greater losses is enhanced.
The best kind of trade is one where the trader does not depend too much on leveraged funds for a trade. The CFTC has recognised this fact, which informed their decision to peg leverage at a maximum of 1:50. Generally speaking, a leverage of 1:100 is an acceptable standard for most retail trading activity. With controlled leverage, holding too many positions with its attendant risk management pitfalls can be prevented, and traders will be better placed to survive losing trades.