By: Amit Achameesing
Submitted: 2010-12-06 16:20:23 | Word Count: 885
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.Basically, leverage means borrowing a certain amount of money to invest in something. In the foreign exchange market,leverage can be seen as the funds borrowed by a forex trader from a forex broker.
Historically, the amount of leverage provided by forex brokers has varied from 50:1 to 700:1.As an example,if the margin required by the broker is 0.5%, this means that you have to put only $50 to trade $10,000 worth of currencies. The point to understand here is simple.Forex margin and leverage are very much related to each other so much so that in the above example you would leverage your margin to trade a much larger value of currencies which is $10,000 in this case. This is in fact the main idea behind the concept of margin-based leverage.
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In the currency market, prices move in very small increments which are called pips. 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 explains why foreign exchange trading should be carried out in large amounts of money so as to permit these small incremental moves to translate into measurable profits or losses. However, compared to big banks and other financial institutions retail traders do not have the means to trade foreign exchange in thousands of dollars. This is seen as the major reason why such high leverage is available in the forex market.
Though you can use leverage to make substantial profits,this tool can be equally dangerous . Let us now take an example to see why and how this occurs. There are two retail traders Y and Z and each has $5000 as trading capital. They also trade with the same forex broker who requires 1% margin deposit.After analysing the charts they conclude that the USD/CHF has reached a peak and forecast that it will fall in value. Y and Z decide to sell USD/CHF at 1.1200 .
Trader Y who likes risks applies 100 times real leverage on his $5,000, and therefore shorts $500,000 worth of currencies (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.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!
Trader Z who does not like to handle big risks applies only 5 times real leverage on this trade and so shorts only $25,000 worth of the currency pair (5 x $5000).This $25,000 represents only one-quarter of 1 standard lot. When USD/CHF increases to 1.1300, that is, by 100 pips, Trader Z loses $223. But here the percentage that Trader Y loses is much smaller compared to Trader Z, and is in fact only 4.46% of his trading capital.
Let us now consider the difference between real leverage and margin-based leverage.From the above example, Trader Y has used a real leverage of 100 times while Trader Z has used a real leverage of only 5 times.For margin-based leverage broker X allows both traders to leverage their margin by 100 times. However it is real leverage which is dangerous because you trade positions which are much larger than what you can really afford. For example, in terms of margin-based leverage Y has put $1,000 margin for each $100,000 and with real leverage has bought $500,000 with his trading capital of $5,000. In this sense he has used real leverage of $500,000/$5,000 =100:1. If he had bought only $100,000 of USD/CHF he would have used only 20 times real leverage and lost much less.
The explanation above should now give you a clearer picture why the CFTC has decided to reduce leverage to 50:1 for major currency pairs such as the USD/CHF. If broker X is forced to increase his margin from 1% to 2% (decrease his leverage from 100:1 to 50:1), this means that our Trader Y would also be forced to use less real leverage and as such would lose much less. On 18th October 2010 the CFTC has imposed a new rule on forex brokers requiring them to reduce leverage to 50:1 for major currency pairs .
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.
