How Much Leverage Is Right for You in Forex Trades

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How Much Leverage Is Right for You in Forex Trades - Understanding how to trade foreign currencies requires detailed knowledge about the economies and political situations of individual countries, global macroeconomics and the impact of volatility on specific markets. But the truth is, it isn’t usually economics or global finance that trip up first-time forex traders. Instead, a basic lack of knowledge on how to use leverage is often at the root of trading losses.

Data disclosed by the largest foreign-exchange brokerages as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act indicates that a majority of retail forex customers lose money. The misuse of leverage is often viewed as the reason for these losses. This article explains the risks of high leverage in the forex markets, outlines ways to offset risky leverage levels and educates readers on ways to pick the right level of exposure for their comfort. (For an introduction to currency trading, read Forex Tutorial: The Forex Market.)

The Risks of High Leverage
Leverage is a process in which an investor borrows money in order to invest in or purchase something. In forex trading, capital is typically acquired from a broker. While forex traders are able to borrow significant amounts of capital on initial margin requirements, they can gain even more from successful trades. (For more read How does leverage work in the forex market?)

In the past, many brokers were able to offer significant leverage ratios as high as 400:1. This means, that with only a $250 deposit, a trader could control roughly $100,000 in currency on the global forex markets. However, financial regulations in 2010 limited the leverage ratio that brokers could offer to U.S.-based traders to 50:1 (still a rather large amount). This means that with the same $250 deposit, traders can control $12,500 in currency.

So, should a new currency trader select a low level of leverage such as 5:1 or roll the dice and ratchet the ratio up to 50:1? Before answering, it’s important to take a look at examples showing the amount of money that can be gained or lost with various levels of leverage.

Example Using Maximum Leverage
Imagine Trader A has an account with $10,000 cash. He decides to use the 50:1 leverage, which means that he can trade up to $500,000. In the world of forex, this represents five standard lots. There are three basic trade sizes in forex: a standard lot (100,000 units of quote currency), a mini lot (10,000 units of base currency), and a micro lot (1,000 units of quote currency). Movements are measured in pips. Each one-pip movement in a standard lot is a 10 unit change.

Because the trader purchased five standard lots, each one-pip movement will cost $50 ($10 change/standard lot X 5 standard lots). If the trade goes against the investor by 50 pips, the investor would lose 50 pips X $50 = $2,500. This is 25% of the total $10,000 trading account.

Example Using Less Leverage
Let’s move on to Trader B. Instead of maxing out leverage at 50:1, she chooses a more conservative leverage of 5:1. If Trader B has an account with $10,000 cash, she will be able to trade $50,000 of currency. Each mini-lot would cost $10,000. In a mini lot, each pip is a $1 change. Since Trader B has 5 mini lots, each pip is a $5 change.

Should the investment fall that same amount, by 50 pips, then the trader would lose 50 pips X $5 = $250. This is just 2.5% of the total position. (For a detailed explanation of how leverage works, read Forex Leverage: A Double-Edged Sword.)

Can Forex Trading Make You Rich?

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Can Forex Trading Make You Rich? - Can forex trading make you rich? Although our instinctive reaction to that question would be an unequivocal "No,” we should qualify that response. Forex trading may make you rich if you are a hedge fund with deep pockets or an unusually skilled currency trader. But for the average retail trader, rather than being an easy road to riches, forex trading can be a rocky highway to enormous losses and potential penury.

But first, the stats. A Bloomberg article in November 2014 noted that based on reports to their clients by two of the biggest publicly traded forex companies – Gain Capital Holdings Inc. (GCAP
GCAP
Gain Capital Holdings Inc
7.31
+0.14%

) and FXCM Inc. (FXCM) – 68% of investors had a net loss from trading currencies in each of the past four quarters. While this could be interpreted to mean that about one in three traders does not lose money trading currencies, that's not the same as getting rich trading forex.

Note that those numbers were cited just two months before an unexpected seismic shock in the currency markets highlighted the risks of forex trading by retail investors. On January 15, 2015, the Swiss National Bank abandoned the Swiss franc's cap of 1.20 against the euro that it had in place for three years. As a result, the Swiss franc soared as much as 41% against the euro and 38% versus the U.S. dollar on that day.

The surprise move inflicted losses running into the hundreds of millions of dollars on innumerable participants in forex trading, from small retail investors to large banks. Losses in retail trading accounts wiped out the capital of at least three brokerages, rendering them insolvent, and took FXCM, then the largest retail forex brokerage in the United States, to the verge of bankruptcy.

Here then, are seven reasons why the odds are stacked against the retail trader who wants to get rich through forex trading.

Excessive Leverage: Although currencies can be volatile, violent gyrations like that of the aforementioned Swiss franc are not that common. For example, a substantial move that takes the euro from 1.20 to 1.10 versus the USD over a week is still a change of less than 10%. Stocks, on the other hand, can easily trade up or down 20% or more in a single day. But the allure of forex trading lies in the huge leverage provided by forex brokerages, which can magnify gains (and losses).
A trader who shorts EUR 5,000 at 1.20 to the USD and then covers the short position at 1.10 would make a tidy profit of $500 or 8.33%. If the trader used the maximum leverage of 50:1 permitted in the U.S. for trading the euro, ignoring trading costs and commissions, the potential profit would have been $25,000, or 416.67%. (For an explanation of how to calculate forex P/L, see How leverage is used in forex trading.)

Of course, had the trader been long euro at 1.20, used 50:1 leverage, and exited the trade at 1.10 to the USD, the potential loss would have been $25,000. In some overseas jurisdictions, leverage can be as much as 200:1 or even higher. Because excessive leverage is the single-biggest risk factor in retail forex trading, regulators in a number of nations are clamping down on it.

The 6 Most-Traded Currencies And Why They're So Popular

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The 6 Most-Traded Currencies And Why They're So Popular The forex market is the world's largest and most liquid market, with trillions of dollars traded on any given day between millions of parties. For those just getting started in the forex market, one of the first steps is to gain familiarity with some of the more commonly traded currencies and their popular uses in not only the forex market but in general as well. Let's take a look at several popular currencies that all forex observers should be acquainted with and some of the underlying traits and characteristics of each. (Learn about the forex market and some beginner trading strategies to get started. For more, see Forex Trading: A Beginner's Guide.)
TUTORIAL: Introduction to Currency Trading

1. The U.S. Dollar
First and foremost is the U.S. dollar, which is easily the most traded currency on the planet. The USD can be found in a pair with all the other major currencies and often acts as the intermediary in triangular currency transactions. This is all because the USD acts as the unofficial global reserve currency, held by nearly every central bank and institutional investment entity in the world. (For more, see Profiting From A Weak Dollar.)

In addition, due to the U.S. dollar's global acceptance, it is used by some countries as an official currency, as opposed to a local currency, a practice known as dollarization. As well, the U.S. dollar may be widely accepted in other nations, acting as an informal alternative form of payment, while those nations maintain their official local currency.


The dollar is also an important factor in the foreign exchange rate market for other currencies, where it may act as a benchmark or target rate for countries that choose to fix or peg their currencies to the USD's value. For instance, as of 2011, China has its currency, the renminbi, still pegged to the dollar, much to the disagreement of many economists and central bankers. Quite often countries will fix their exchange rates to the USD to stabilize their exchange rate, rather than allowing the free (forex) markets to fluctuate its relative value. (For more, see The Pros And Cons Of A Pegged Exchange Rate.)

One other feature of the USD that is important for novices in forex to understand is that the dollar is used as the standard currency for most commodities, such as crude oil and precious metals. So what's important to understand is that these commodities are subject to not only fluctuations in value due to the basic economic principals of supply and demand but also the relative value of the U.S. dollar, with prices highly sensitive to inflation and U.S. interest rates, which directly affect the dollar's value.

2. The Euro
Although relatively new to the world stage, the euro has quickly become the second most traded currency behind only the U.S. dollar. As well, the euro is the world's second largest reserve currency. The official currency of the majority of the nations within the eurozone, the euro was introduced to the world markets on January 1, 1999, with banknotes and coinage entering circulation three years later.

Along with being the official currency for most eurozone nations, many nations within Europe and Africa peg their currencies to the euro, for much the same reason that currencies are pegged to the USD- to stabilize the exchange rate..


With the euro being a widely used and trusted currency, it is very prevalent in the forex market, and adds liquidity to any currency pair it trades within. The euro is commonly traded by speculators as a play on the general health of the eurozone and its member nations. Political events within the eurozone can often lead to large trading volumes for the euro, especially in relation to nations that saw their local interest rates fall dramatically at the time of the euro's inception, notably Italy, Greece, Spain and Portugal. The euro may be the most "politicized" currency actively traded in the forex market. (For more, see Top 7 Questions About Currency Trading Answered.)

The Forex Market

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The Forex MarketThe foreign exchange market (forex or FX for short) is one of the most exciting, fast-paced markets around. Until recently, forex trading in the currency market had been the domain of large financial institutions, corporations, central banks, hedge funds and extremely wealthy individuals. The emergence of the internet has changed all of this, and now it is possible for average investors to buy and sell currencies easily with the click of a mouse through online brokerage accounts.

Daily currency fluctuations are usually very small. Most currency pairs move less than one cent per day, representing a less than 1% change in the value of the currency. This makes foreign exchange one of the least volatile financial markets around. Therefore, many currency speculators rely on the availability of enormous leverage to increase the value of potential movements. In the retail forex market, leverage can be as much as 250:1. Higher leverage can be extremely risky, but because of round-the-clock trading and deep liquidity, foreign exchange brokers have been able to make high leverage an industry standard in order to make the movements meaningful for currency traders.

Extreme liquidity and the availability of high leverage have helped to spur the market's rapid growth and made it the ideal place for many traders. Positions can be opened and closed within minutes or can be held for months. Currency prices are based on objective considerations of supply and demand and cannot be manipulated easily because the size of the market does not allow even the largest players, such as central banks, to move prices at will.

The forex market provides plenty of opportunity for investors. However, in order to be successful, a currency trader has to understand the basics behind currency movements.

The goal of this forex tutorial is to provide a foundation for investors or traders who are new to the foreign currency markets. We'll cover the basics of exchange rates, the market's history and the key concepts you need to understand in order to be able to participate in this market. We'll also venture into how to start trading foreign currencies and the different types of strategies that can be employed.

Forex Tutorial: How To Trade & Open A Forex Account

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Forex Tutorial: How To Trade & Open A Forex Account 

So, you think you are ready to trade? Make sure you read this section to learn how you can go about setting up a forex account so that you can start trading currencies. We'll also mention other factors that you should be aware of before you take this step. We will then discuss how to trade forex and the different types of orders that can be placed.

Opening A Forex Brokerage Account
Trading forex is similar to the equity market because individuals interested in trading need to open up a trading account. Like the equity market, each forex account and the services it provides differ, so it is important that you find the right one. Below we will talk about some of the factors that should be considered when selecting a forex account.

Leverage
Leverage is basically the ability to control large amounts of capital, using very little of your own capital; the higher the leverage, the higher the level of risk. The amount of leverage on an account differs depending on the account itself, but most use a factor of at least 50:1, with some being as high as 250:1. A leverage factor of 50:1 means that for every dollar you have in your account you control up to $50. For example, if a trader has $1,000 in his or her account, the broker will lend that person $50,000 to trade in the market. This leverage also makes your margin, or the amount you have to have in the account to trade a certain amount, very low. In equities, margin is usually at least 50%, while the leverage of 50:1 is equivalent to 2%.

Leverage is seen as a major benefit of forex trading, as it allows you to make large gains with a small investment. However, leverage can also be an extreme negative if a trade moves against you because your losses also are amplified by the leverage. With this kind of leverage, there is the real possibility that you can lose more than you invested - although most firms have protective stops preventing an account from going negative. For this reason, it is vital that you remember this when opening an account and that when you determine your desired leverage you understand the risks involved.

Commissions and Fees
Another major benefit of forex accounts is that trading within them is done on a commission-free basis. This is unlike equity accounts, in which you pay the broker a fee for each trade. The reason for this is that you are dealing directly with market makers and do not have to go through other parties like brokers.

This may sound too good to be true, but rest assured that market makers are still making money each time you trade. Remember the bid and ask from the previous section? Each time a trade is made, it is the market makers that capture the spread between these two. Therefore, if the bid/ask for a foreign currency is 1.5200/50, the market maker captures the difference (50 basis points).

If you are planning on opening a forex account, it is important to know that each firm has different spreads on foreign currency pairs traded through them. While they will often differ by only a few pips (0.0001), this can be meaningful if you trade a lot over time. So when opening an account make sure to find out the pip spread that it has on foreign currency pairs you are looking to trade.

Other Factors
There are a lot of differences between each forex firm and the accounts they offer, so it is important to review each before making a commitment. Each company will offer different levels of services and programs along with fees above and beyond actual trading costs. Also, due to the less regulated nature of the forex market, it is important to go with a reputable company. (For more information on what to look for when opening an account, read Wading Into The Currency Market. If you are not ready to open a "real money" account but want to try your hand at forex trading, read Demo Before You Dive In.)