Over the last ten years there has been a constant increase in the number of people who trade currencies, and this is explained by the fact that the forex market offers a much higher leverage than the stock and futures markets.At an elementary level leverage means using a few hundred dollars to trade positions which are worth thousands of dollars. In forex, leverage is a loan provided by the forex broker to the forex retail trader.
In fact the amount of leverage offered by forex brokers usually varied from 50:1 to 200:1.For example, with a broker margin of 2%, you have to put only $200 to trade $10,000 worth of currencies. As you can see here, forex margin and forex leverage are strongly linked to each other so much so that in this example you would leverage your margin to trade a much larger value of currencies. In fact this is the reasoning behind the term margin-based leverage.
In trading forex, prices usually fluctuate by pips, which is the smallest change in currency prices. If we take the USD/CHF a 100 pip move occurs when price moves say from 1.1200 to 1300, and this represents only a $0.01 move in the value of the 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 big banks most people do not have large sums of money to trade foreign exchange. This is advocated to be the main reason why there is relatively higher leverage in the currency market.
Although leverage increases your ability to make large profits,if not used correctly you can blow up all the money in your trading account. Let us see why and how this happens. Y and Z are our two traders and each has $5000 in their trading account. In addition each has a trading account with broker X who requires a margin deposit of 1%.After looking at the charts both agree that the upward trend in USD/CHF has lost its momentum. They forecast a large downward correction, and so both decide to short the currency pair at 1.1200.
Y who is a risk lover decides to apply maximum real leverage of 100 on his $5000, and so shorts $500,000 worth of USD/CHF (100 x $5,000) .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.As the trade unfolds the price of USD/CHF increases to 1.1300 instead of falling to 1.1100, and trader Y loses $4,460. This 100 pips loss equals to $4,460 which also represents a loss of 89.2% of Y's trading capital!
Trader Z who is far less adventurous decides to apply 5 times real leverage on his trading capital, and so sells only $25,000 of USD/CHF (5 x $5,000).In effect the amount that Trader Z buys is only one-quarter of one standard lot. Again as the market price moves to 1.1300, Trader Z loses 100 pips which equals to $223. The percentage of his trading capital that Z loses is 4.46% which is much smaller than the 89.2% of Trader Y.
It would be relevant to make the distinction between margin-based leverage and real leverage.As we have seen in this example Trader Z has used real leverage of 5 times whereas Y has used 100 times maximum real leverage.As the broker reuires 1% margin in terms of margin based leverage it means that Y has used 100 times margin-based leverage because has traded $100,000 with only $1,000. His real leverage for the trade is calculated by taking $500,000 divided by $5,000 which equals to 100:1. In fact if he had bought only 1 standard lot, that is, only $100,000 worth of currencies, he would have used only 20 times real leverage and lost less money. The lesson to remember here is : Real leverage is a double-edged sword. This is especially true because imagine the profits Y would have made if the trade was a good one.
The example above should now shed some light on the intentions of the CFTC. If regulations are imposed on broker X and force him to reduce his leverage from 100:1 to 50:1 this implies that our Trader Y would also be forced to reduce his real leverage to 50:1. He would then lose less money than when he used 100:1 real leverage . This is why on the 30th August 2010, the CFTC has finally decided to limit leverage for major currency pairs to 50:1. This decision by the CFTC came into effect on 18th of October 2010.
Author Resource:-
Learn about forex leverage and other key concepts you need to be aware of when choosing forex brokers.These concepts are explained by forex expert Amit Achameesing.
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