The use of leverage is an opportunity to increase the volume of investments due to credit funds borrowed from a broker. As collateral for this loan, funds are used that are in the account of the trader, called margin.
The amount of loan funds available to the trader is determined by the broker’s margin requirements. Margin requirements are usually 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 number of available customer funds must be at least 2% of the total transaction amount. In this case, the leverage is 1:50. Using the leverage of 1:50 allows the trader to operate on the market for $ 50,000, having only $ 1,000 in his account. For such leverage, a 2% movement of a trading instrument on 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, onUS stock market, the margin level is usually 50%, that is, a leverage of 1: 2 is used. In futures markets, borrowed funds are used much more actively – depending on the contract, the leverage can reach 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 The availability of borrowed funds and the low minimum requirements for an initial deposit made the Forex market accessible to private traders. However, excessive use of credit funds is one of the main reasons for the devastation of traders’ accounts.
Read more about using leverage in the article Leverage on Forex two-way stick
The danger of using large leverage is recognized by US regulatory authorities that have established certain restrictions. In August 2010, the United States Derivatives Exchange Commission (CFTC) issued the final Forex trading rules limiting leverage for private traders to 1:50 for major currency pairs and to 1:20 for other currency pairs.
As of 2013, in other countries, leverage of 1: 400 and higher is still used.
Example of margin trading on Forex.
Let’s say we use a leverage of 1: 100. In this case, for trading a standard lot of $ 100,000, we need to have only $ 1000 in our trading account. If we buy 1 standard USD / CAD lot at 1.0310, after which the cost of this currency pair will increase 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 result in a 100% loss. Now, suppose the leverage is 1:50. In this case, we need to have $ 2,000 on our account to trade 1 standard lot (2% of $ 100,000). If we buy 1 standard USD / CAD lot at 1.0310, and the value of this currency pair grows by 1% to 1.0413, the increase in funds in 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 a 50% loss of capital.
The movement of the value of a currency pair by 1% 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 unprofitable transactions can lead to a complete loss of capital. Of course, it is tempting to get 50% or 100% profit per transaction, but the chances of success for a long time using a large leverage are small. Successful professional traders often make several losing trades in a row, but they can still continue trading through the proper use of borrowed funds. Consider another case. Suppose the leverage is 1: 5. In this case, marginal requirements for trading with a standard lot of $ 100,000 are $ 20,000. If the transaction is unsuccessful, and the currency pair goes 1% in the direction opposite to the direction of the transaction, the trader’s losses will be limited to only 5%.
Fortunately, many brokers offer micro lot trading, which allows traders to use a leverage of 1: 5 in small accounts. Micro lot – a contract for 1000 units of the base currency. Micro lots are an excellent tool for beginning traders and for traders with a limited amount of capital.
Margin call (margin requirement)
When opening a transaction, the broker monitors the residual value of assets (amount of funds) in 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. Credit shoulder and management of cash resources ( mani – Management )
Using large leverage is fundamentally opposed to money management principles when trading on Forex. The main generally accepted principle of money management is the use of small leverage and stops so that the risk on one transaction does not exceed 1-2% of the total amount held on the trader’s account.
According to the largest brokerage firms, most private traders lose money when trading on Forex. The main (if not the main) reason for the failure of private traders is the excessive use of borrowed funds. Nevertheless, the use of leverage provides the trader with freedom and allows the efficient use of available capital. 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.