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You hear a lot about the incredible 400:1 leverage in a Forex mini account but what does it really mean? Is it an advantage to the beginning trader or a liability? What choices to you have in using it? Why and how is it offered by the Forex brokerages? These are important questions the beginning Forex Trader should be asking and getting good answers to.

First of all what is Leverage? Well in physics it is the use of a lever to move or control something you ordinarily could not. By placing a long stick under a huge rock and placing a small rock under the stick near the large rock you have created a leverage situation. Then by pushing down easily on the far end of the long stick “magic” the large rock you could not have moved or controlled on your own moves easily. The longer the stick the bigger a rock you can move with the same effort.

How does leverage work in investing? Leverage in investing is an application of the same basic principles only now the “large rock” is a house or a car or 1,000 shares of stock or a futures contract for 1,000 barrels of oil or $100,000 in Forex currency trading that you would like to control. The “small rock” in the case of the house or car is your down payment (this down payment is called margin in the stock, futures or Forex trading language). In either case it is the amount of money that you are putting up as collateral on the loan. The “long stick” is the remaining amount of money that you are being loaned by the bank or the Stock, Futures, or Forex Brokerage and the length of time or other conditions of the loan. The less you have to put down the longer the stick the bigger “rock” you can control.

So what kind of leverage is usual in finance? Well the principle is normally, the less risk involved in the financial transaction the more leverage the lender will allow.

In the Stock Market since the risk of loss is high for beginning traders they are given no leverage at all, if they want to buy 1,000 shares of stock at $10.00 a share they will need to pay $10,000 from their account for this stock plus any commission. After the Stock Brokerage becomes confident that you know what you are doing in your stock investing they will offer a “margin account” to you and for the same transaction you will only have to put up $5,000 and they will “loan” you the other $5,000 for the stock and charge you a small amount of margin interest for the loan, you have been given leverage of 2:1 or 50%. If the stock trade goes against you and your account dwindles down to the point where you no longer have 50% of the value of the stock in your account you will get a call from the stock broker informing you that you need to add more money to your account, more “margin” to make your part of the deal 50% again. This is called a margin call. If you fail to come up with the needed extra money, your stock is sold they take back their money (50% of the original stock price plus interest) and you have what ever is left in your account after the stock is sold or you are billed for the difference if you have nothing left in your account.
In the Real Estate market you are seeking to gain ownership or control of a house and a down payment of 10-20% so you are being loaned 80-90% of the value of the house or a leverage of 8:1 or 9:1. This higher leverage is usual in the Real Estate Market because the lender feels more confident in loaning you the money because the loan is secured by a mortgage on the home and the lender can take the house as collateral if you fail to pay the loan as agreed, this is called foreclosure.

In the Futures Market even higher levels of leverage exist, and it is much more complicated than I care to go into here, but in essence you are putting down as little as 2% as margin, or 80:1 leverage. In this case a different principle is involved in deciding how much leverage is allowed the trader. The leverage is still determined by the degree of safety for the lender in making the loan but the reason for the safety is different. Let’s call it the increased degree of never-never-land fantasy. The higher leverage is considered okay by the lender because in the majority of Futures Market trading there is actually no delivery of the goods, it is just a speculative trade in the Market and the gold, silver, pork bellies or whatever commodity it is never really has to be delivered, so the real final purchase price of the goods that is being “loaned” to the trader is very unlikely to ever really be needed. And if a Futures trader makes a bad trade, he too like his Stock Market cousins, will get a “margin call” from the broker. He will literally called by the broker telling them the account needs to have more money put in immediately to keep the trades open. If the trader does not put more in the account the trades are closed at a loss and he not only has lost his account he owes the remainder of the loss beyond what he had in the account to start with. You can definitely lose more than you started with in Futures Trading. So Futures trading is for those with deep pockets and definitely not for the faint of heart!

In the Forex market the highest levels of leverage in individual trading exist. Leverage of 100:1, 200:1 even 400:1 are common even for brand new traders with no experience; in fact this high leverage is marketed especially to brand new traders with no experience. It is being used as a big draw for them to get into the Forex market, because they can open a trading account with only $200 or $300. Why such high leverage? Same basic lending principles apply as before. Higher leverage is granted by a lender to the degree they feel safe that they will not lose on the loan.

So why do they feel so safe? Well let us look at the facts. One big difference in FX trading and Stock or Futures trading is that there are seldom if ever margin calls. The trades all are just automatically closed if you run low on margin. You still have something in your account, but the trades that went against you are over. In this way the broker is covered, he can’t lose, and he doesn’t have to call you for more money to put in your account which you might not be able to come up with. Another difference in FX trading is that in these high leverage trades you are actually not trading with the real Forex Market your trades are being taken in house, by professional traders trading against you in the brokerage house. If this makes you a little uneasy, it should.

Industry analysts say that over 80% of new Forex traders bust out in 30 days and close the account. Not so good for the new trader, but pretty safe bet for the lender. The 80%er new trader puts up $300 or $3000 in his account and starts trading the Forex Market trading “against the house” doesn’t really know what he is doing or is given poor trading advice, loses 90% of his account and quits. Where did that money go? It stayed with the broker.

So what do you do, just quit now and be ahead of the game? Should you never use the high leverage available to you in Forex trading? No, you just must make very sure you know what the rules of the game are and make correct decisions. Be in the 20% that wins in Forex! You absolutely MUST know what you are doing when you trade. You must have a proven workable Trade Plan that is routinely at least 75% profitable when you use it. You must have discipline to follow that plan and use it to keep your losses small, let your winnings run and so build up your account.

Leverage to the unwary can be a wicked foe, but if you understand how it works and use it wisely it can be a powerful ally.

Best to you in trading,
Phil

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1 Comment

Comment by Jonty
2007-11-30 03:30:42

Under the heading of futures trading you refer to “putting down as little as 2% or 80:1 leverage”. Not sure if it is a typo or legitimate error. As I have it the 2% is the margin requirement and 2% margin will allow leverage of 50:1, not 80:1.

In this article there is a very important omission of two small words which has been omitted from forex websites for very long but recently it started to appear and I guess it came from regulatory pressure. These two words are “up to”. In the forex market you can trade with leverage “up to” 100, 200, 400:1.

The reason is that effective or real leverage isn’t the maximum you can get because in forex your loss is not limited to say 1% (100:1) if your capital. In fact you put down all your capital as margin (it is in the broker’s account in any case) and your leverage is the relationship between your total capital and the size of the position you trade. So if you have a $10,000 account and trade GBPUSD of 100K the leverage = 100,000*exchange rate (2.00)/10,000 = 20:1. It is really irrelevant that the broker wants only 1% or 0.5% or 0.25% margin.

The illusion is created that even if you trade one, two or three lots you trade with the same amount of leverage, which is nonsense and the cause for lots of wiped out accounts.

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