Currency traders employ what is known as Leverage or Margin to make trades on the foreign exchange market. If, for example, you choose to come into the market, you can make a trade with other people’s money – a forex broker’s money.
How Leverage and Margin Trading Works
In the Foreign Exchange Market, Leverage is the ability to buy more currency than what you actually have in your Trading Account. If, for example, you wanted to buy a position worth $10,000, you could then purchase this position for only $200 of your own funds. The Broker would put up the other $9,800. This would be 1:50 Leverage, since you need only put up $1 to buy $50 worth of currency.
Leverage is what makes Foreign Exchange Trading so profitable. In buying a Leveraged Position, you can effectively control huge piles of currency without putting up a lot of money yourself. And even though you don’t put up a lot of money, you still get all the upside in the currency movements!
Let’s go back to our trade table to see how Leverage affects currency trades:
|Trades||Amount of Pounds||Amount of Dollars|
|Purchase 5,000 Pounds for 8,000 US Dollars, at a rate of 1.6000||Add 5,000 Pounds||Subtract 8,000 Dollars|
|Sell 5,000 Pounds for 8,770 US Dollars at a rate of 1.7400||Subtract 5,000 Pounds||Add 8,700 Dollars|
|Profit & Loss:||5,000 – 5,000 = 0||$8,700 – $8,000 = $700|
In this example we purchased 5,000 GBP for $8,000. In reality, a Trader will only need $160 to place this trade at 1:50 Leverage, since the funds are multiplied and matched by the Forex Broker.
To buy this position, you would choose to buy GBPUSD, and your Trading Account will be Debited (-) by $160 in Cash Balance. Upon closing the position, it would be Credited (+) with $700 (the profit from the change in currency pairs) plus your initial investment of $160. All in all, the above trade would Net a $700 Profit on a $160 investment, or a Total Return of 437% on a 8.75% change in currency values.
Why Forex Trading is so Lucrative:
- Forex does not require a large investment
- You can grow your return with Leverage
- Being able to identify small moves in currency prices will result in great profit.
For example, if you are required to Deposit 1% of the total transaction value as margin and you intend to trade one standard lot of USDCHF which is equivalent to $100,000, the margin required would be $ 1,000. Thus, your margin-based Leverage will be 1:100 (1,000/100,000). For a margin requirement of just 0.25%, the margin-base leverage will be 1:400 using the same formula.
|Margin-Based Leverage (Expressed as a Ratio)||Margin Required of Total Transaction Value|
Risk of the Excessive Real Leverage
Real Leverage has the potential to enlarge your Profits or Losses by the same magnitude. The greater the amount of Leverage on capital you apply, the higher the Risk that you will assume. Note that this risk is not necessarily related to Margin Based Leverage, although it can influence, if you are careless as a Trader.
Both Trader A and B have a Trading Capital of $10,000, and they trade with a Broker that requires a 1% Margin Deposit. After doing some analysis, both of them agree that USDJPY is hitting a top and should fall in value. Therefore, both of them short the USDJPY at 120.
Trader A chooses to apply 50 times real leverage (1:50) in this trade by shorting $500,000 worth of USDJPY (50 x $10,000) base on his $10,000 Trading Capital. Because USDJPY stands at 120, one pip of USDJPY for one standard lot is worth approximately $8.30, so one Pip of USD/JPY for five standard lots is worth approximately US$41.50. If USDJPY rises to 121, Trader A will lose 100 pips on this trade, which is equivalent to a Loss of $4,150. This single loss will represent a whopping 41.5% of his Total Trading Capital.
Trader B is a more careful trader and decides to apply five times real leverage (1:5) on this trade by shorting US$50,000 worth of USD/JPY (5 x $10,000) base on his $10,000 trading capital. That $50,000 worth of USDJPY equal to just one-half of one Standard Lot. If USDJPY rises to 121, Trader B will lose 100 pips on this trade, which is equivalent to a Loss of $415. This single loss represents 4.15% of his total Trading Capital.
Refer to the chart below to see how the trading accounts of these two traders compare after the 100-pip loss.
|Trader A||Trader b|
|Real Leverage used||1:50||1:5|
|Total Value of Transaction||$500,000||$50,000|
|In case of a 100 Pip Loss||- $4,150||- $415|
|% Loss in Trading Capital||41.5%||4.15%|
|% of Trading Capital Remaining||58.5%||95.8%|