Leverage in Forex Trading – A close look at one of the most intriguing elements of forex trading
It’s no secret that forex traders have a healthy appetite for high leverage. However, all too often high Leverage is a nasty trick played by retail brokers to dazzle traders with a utopian and false promise of a windfall of earnings which are simply not realistic.
In this article, we’ll help you understand how toxic and addictive high leverage can be and why you don’t even need leverage to make a great living from trading.
Here’s the short, straightforward version – we don’t like high leverage. However, if you read on we’re going to share a simple concept that will allow you to use leverage in a helpful, constructive way.
If it’s used in the right and responsible way, leverage can work to your benefit. But if you’re not aware enough, it can also wipe out months of hard work, real quick.
Leverage in forex is given in proportion to the trader’s available securities capital deposited in the trader’s trading account. For every single dollar, you have free for trading, the broker will let you use multiples of the market value. For example, if you have $10,000 in your forex account, and the broker set your account with a leverage of 100:1, you would have a potential market value of $10,000 X 100 = One million dollars position value. Every dollar you put in the market, the broker will multiply your buying position and give you 100 dollars.
While the account is set for high leverage, you will still have full control of the final position market value. That’s good news because brokers allow you to play responsibly if you want. For example, if you have $10,000 in the account and you wish to buy $50,000 worth of assets and the account is set to 100:1 leverage, your position will use only 50,000 / 100 which equals only $500 from your deposited securities. You were using only 5:1 leverage. 5 times the actual capital amount of money you brought from home.
Trading with a leveraged position has two sides. You can earn more by multiples but you can also blow through your account fast. Using a 100:1 position means you can double your securities if price changes in your favor only 1%. At the same time, it can also wipe your whole investment if the price moves against your position with only 1%.
Tactical retracement price moves are the very nature of price action movements. Even if you are right with the market direction bias, you can easily be caught on a deep tactical retracement. Therefore using high leverage is considered gambling and has no risk management logic to it.
If you have an appetite for destruction, feel free to use leverage. Just know that it has a well known ending to it. But if your goal in trading is to be serious, responsible, and consistent, you should not use leverage at all. In fact, you can do very well using only negative leverage. At this point, it’s best to stress the numbers behind this practice.
From a risk management perspective, trading using high leverage has a devastating effect on your overall performance. Trading is a risk management game in an unpredictable environment. If you agree with this statement, you must give your activity enough margin for error and for recovery from uncontrolled sequences of consecutive losses.
By using high leverage, there is less room to recover when the market plays against your bias. You will not have enough breathing drawdown to take with your position before the market reverses back in your favor. As high as the leverage is, so is the risk. Therefore, breaking into smaller risk units per single trade allows larger sequences of consecutive losses.
Brokers know the human psychological state and its appetite for temptations and thrills. It’s like giving a 12-year-old child a 1,000cc motorbike without a helmet. It only takes one fall to be seriously hurt.
There is another fact that works against people who leverage. As long as the winners come, the appetite for more only grows and overconfidence takes over. However, like the motorbike scenario, when the winning side is endless, it is only up to the trader to quit. In contrast, the losing side is very limited. And it eventually happens, and it will eventually consume everything that was made prior.
So why do brokers provide this to traders and how is it possible for brokers to reach into their pockets and give traders 100 dollars for every 1 dollar deposited with them?
The answer is simple. Retail brokers make better profits for themselves by giving leverage and can give leverage to their traders at no extra cost for them whatsoever. How is that so?
To understand why and how it is possible for brokers to hand out such high amounts of leverage to traders, we have to first understand what retail is for brokers and what their key business model is. The Forex brokers most of us will ever know are Retail Forex Brokers. This is opposed to a prime broker, as retail brokers are privately owned.
Retail brokers, including ones from highly regulated regions, are not obligated to buy your trading positions in the true market. Since forex is a distributed market with no central exchange, there is not a practical or possible method to enforce back to back order filling in the market. In fact, the regulators allow retail brokers to be market makers for their traders as long as they respect the client’s balance in their account.
When you trade with a retail forex broker, you buy a CFD asset. CFD stands for Contract for Difference. This means you are buying a contract that was issued by the broker you trade with for the differences in price between your entry price and exit price. The broker is the sole issuer of this contract and as long as they respect the contract with their traders, the regulators are OK with this setup. You should be too because as a speculative currencies trader, this is the only way to be. For the most part, regulators are doing a fair job protecting your side.
CFD also means that when you’re closing your trade the contract ends and the broker collects or pays only the change difference in the value of the position. For example, if you were buying 10,000 Euros by the US dollar (0.1 LOT of EURUSD) at a price of 1.1000, and you then sold it back at a price of 1.1050, the contract commitment for the broker is to add $50 to your account balance for 50 pips in profit. If you sold at 1.0050, then the broker is allowed to deduct $50 from your account securities for a 50 pips loss.
Working off the same example, when a trader takes leverage from the broker, let’s say 10:1 and the position market value is 100,000 Euros, the profit the trader earns is $500, or if closed at a loss of 50 pips the account will deduct $500. At 20:1 leverage that will be $1,000 either side, at 50:1 is $2,500… you can do the math.
The point is, brokers will give you any amount of market value, as long as you have enough money to pay for the difference in case you lose.
Since these are just contracts between you and the broker and the retail broker is not committed to clear your position anywhere else, the broker can practically give you as much leverage as you want and as much as the regulator allows them to give because they do not buy any positions elsewhere. It is a virtual trust agreement between you and the licensed broker.
If any of this sounds fishy, we must emphasize that this is a very legit business as long as the broker respects the contract and plays by the regulator rules. Yet, it is just a trust contract affected by the official rates feed, essentially the same as placing a bet on a sports game.
To sum up until this point: Retail brokers sell CFD contracts that are not backed up with the real holdings of an asset. The contract defines who pays or collects once the trade is closed by the change in rates. Therefore, the broker can provide as much leverage as you could ask for.
This is the best takeaway from this article. The forex major pairs can give you enough trading opportunities to actually earn a good living without any leverage at all. Here are the numbers: With a 100,000 dollar account at no leverage, you will be trading $1 per pip. This is 1:1, no leverage trading. If you trade 10 days, making every day 10 pips on average, you will be making $100 which is 1% profit in 10 days. 10 pips on average a day can be easily achieved for a well-experienced forex trader. Pros who are expecting between 1% to 5% monthly make a fine living.
$100 or $500 monthly is not trading for a living. However, it can come up with a track record of 1 to 5 percent monthly on average, you’ve got a job at any fund and you’ll get investors standing in line for you to handle their investments. With such consistency, you can compound 1% to 5% month after month and you’ll be handling an exponential growth of a serious self-funded account.
However, if you’re tempted by a short cut and use the leverage, the unexpected becomes the most expected to happen. Remember, it is better to progress slow and safe then not progress at all.
In this article, we discussed the two sides of leverage. On one side, it’s multiple earnings, and on the opposite side, it’s the accelerated rate that leaves very little room for error and recovery. Having said that, if you are sophisticated enough with your risk management method, you can use leverage wisely to benefit from the upside of the tool.
The idea is simple but requires plenty of self-restraint and discipline. Because if you break the rule just once, you will break the entire chain of hard work.
Leverage can ONLY be used after you have secured your position for extensive losses. It is actually a very simple yet powerful method to utilize leverage. First, you should be willing to trade swing moves and large price cycles. Because the only way to use leverage in your favor is by starting at no leverage and as price progress in your favor, you can add in more weight to your positions.
Let’s bring in the numbers again to make it clearer:
Say your trading risk policy determines you take only 0.5% risk per trade, and say your account size is $10,000. That equals a $50 risk. Say your position pip value is $1 per pip. You are now risking 50 pips. Once your trade gives you 25 pips you can shift stop loss to break even and add another position the same size. The new position will have a stop loss at 50 pips. You would still be risking $50 while the trade has twice the leverage.
You could also buy twice the size and have the new position stop loss at 25 pips. That would be $2 per pip and still risking $50 while being leveraged 3 times at 3$ per pip on the winning side.
This is an example of how you can gradually compound your position by taking more leverage as the trade progresses positively for you. Many times you might end up taking very little, but for the times the market will not retrace deep to your stop levels, you’ll be taking big cash.
This concept requires a high skill of self-discipline because if you break the rule just once, you will ruin all of your work.
Leverage is a speed trap. It will put you in a place of very tight margins to handle unexpected market events. The psychology of the untrained trader is to be dazzled about the potential to make fast profits and to care less about the very high possibility of losing.
While Brokers are selling their traders contracts for differences and they know the statistics of human nature to ignore risk, it is in their best interest to give high leverage to anyone. Taking leverage is an accident waiting to happen. And it will.
Luckily for us, the forex market is rigid enough to provide multiple entry signals every day, so we can say no thank you to this bait. We can earn our glory without any leverage. A fact that’s been proven time after time.
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