One of the most frequent questions we get asked, is to please increase the leverage on a clients FX trading account. What is it about having huge amounts of leverage that gets so many clients banging on the door and looking for more and do they understand the implications? Is increasing your Forex Leverage always the best option?
What Is Leverage
Leverage in it's most simple form is the ability to use borrowed capital, such as margin, to gain greater exposure to an underlying asset. The simplest example is you looking to buy a R1m house but you only have R100,000. You approach the bank for a loan and they agree to lend you the rest of the money, R900,000. You buy the house and you now have exposure to a R1m dream house for R100,000. Your leverage on this asset is 1:10 and it works exactly the same way in the forex market when trading with your broker.
In forex, investors use leverage to profit from the fluctuations in exchange rates between two different countries. The leverage that is achievable in the forex market is one of the highest that investors can obtain. Leverage is a loan that is provided to an investor by the broker that is handling his or her forex account. When an investor decides to invest in the forex market, he or she must first open up a margin account with a broker. Usually, the amount of leverage provided is either 50:1, 100:1 or 200:1, depending on the broker and the size of the position the investor is trading. Standard trading is done on 100,000 units of currency, so for a trade of this size, the leverage provided is usually 50:1 or 100:1. Leverage of 200:1 is usually used for positions of $50,000 or less. – How Does Leverage Work In The Forex Market, INVESTOPEDIA
Most responsible brokers will open an account for you with a leverage factor of 1:100. This means that for R1,000 you can get exposure to R100,000 of an underlying currency. A small movement in the currency pair will result in 100x the movement of your trading profit or loss. This works out very well when you have chosen the correct direction of the market but not so well when you have picked incorrectly. This amount of leverage available in Forex is one of the highest available to any retail investor and dwarfs the amount of leverage you might get from trading an equity CFD which is typically 10-20x for the most liquid of stocks.
This may sound very risky to offer 1:100 but given that the major currencies do not often move more than 1% on a given trading day, it becomes very manageable for the average trader. When a client starts looking 1:500 or even 1:1000 then these potentially small moves in a currency can have dramatic affects on their trading accounts.
Don't Over Leverage
Traders tend to want to be involved in the markets when they are at their most volatile. It gives them the opportunity to make exceptional gains in a very short space of time. Coupled with high levels of leverage and you have a cocktail that can be very sweet or very bitter depending on whether or not you have chosen correctly.
Many brokers will offer their clients huge amounts of leverage because they realise that over the long term, many will not make money trading. These brokers tend to be market makers, i.e. they take the opposite side of clients' trades. So when the client loses, the company wins and vice versa. The more leverage you give the client, the quicker this process is likely to be and the quicker the broker banks his profit. If the markets happen to gap past your available funds, they are even prepared to write off the additional amount or guarantee against a negative balance.These are the guys in the ivory towers!
Leverage- How Does It Affect The Marker Maker
Other brokers, who hedge each position a client takes will be less inclined to give out huge amounts of leverage because they are then exposed to the client should their trading account become negative. They have lost money to their liquidity provider and must now try and recover the additional amount from the client. An awkward situation all round.
Leverage is an incredibly useful tool and when it is used responsibly can have a dramatic impact on the performance of a clients account. Trading should not be about making millions by the end of the year but the aim of being constantly profitable.