One of the main reasons for so many are attracted to forex trading in relation to the other financial instruments is that with forex you can get much higher leverage than with stocks and futures trading.Put simply leverage means using a small amount of money to trade positions which are worth much more. In the foreign exchange market, leverage can be viewed as the funds borrowed by a forex trader from a forex broker.
Historically, the amount of leverage provided by forex brokers has varied from 50:1 to 700:1.For example, if the broker requires a margin of 2 %, this means that you’ve to deposit only $200 to trade $10, 000 worth of currencies. The point to understand here is simple.Forex margin and leverage are very much related to each other so much so that in the aforesaid example you would leverage your margin to trade a much larger value of currencies which is $10, 000 in this case. Indeed this is the concept which underpins the notion of the margin-based leverage.
In forex, prices move by small amounts and one pip represents the smallest change in currency prices. For example, when a currency pair like the USD/CHF moves 100 pips from 1.1200 to 1.1300, this is only a $0.01 move in the USD/CHF exchange rate. This is why currency transactions have to be undertaken in large amounts, allowing these small price changes to be translated into measurable profits or losses. However, unlike big banks most people don’t have large sums of money to trade foreign exchange. This explains why leverage has been set up in the forex market.
Take USD/EUR = 0.6743 as an example, the price movement of the currency pair is normally less than US$0.01 Or 1 cent a day. The prospect of making a substantial amount of money by trading in this small gap price movement is very limited, as such. This is where the power of forex leverage comes in to play. The earning is now magnified 100 folds with a leverage of 100:1. There are even some brokers who offer forex leverage of up to 500:1, this has thus made the prospect of making huge amount of money big time a possibility.
Do keep in mind also that forex leverage is a double edged sword. It can make earn you big money as well as make you lose big. Leverage is like a magnifying glass. If you could make US$50, 000 on a 100:1 leverage, you could lose that same amount as well from your US$5, 000 initial capital. Hence, knowledge, skills, and adequate risk management are the pre-requisite if you wish to trade successfully.
…And Even More Forex Leverage Example Things
Although leverage increases your capacity to make large profits, if not used correctly you can blow up all the money in your trading account. Let us see why and how this happens. There are two retail traders Y and Z and each has $5000 as trading capital. In addition each has a trading account with broker X who requires a margin deposit of 1%.After looking at the charts both agree that the upward trend in USD/CHF has lost its momentum. They forecast a large downward correction, and so both decide to short the currency pair at 1.1200.
Trader Z who doesn’t like to handle big risks applies only 5 times real leverage on this trade and so shorts only $25, 000 value of the currency pair (5 x $5000).This $25, 000 represents only one-quarter of 1 standard lot. As USD/CHF rises from 1.1200 to 1.1300, Trader Z also loses 100 pips which is here amounted to a loss of $223. This loss represents a relatively lower 4.46% of his trading account.
It is important to note the difference between real leverage and margin-based leverage.In the example above Trader Z has used a real leverage of 5 times whereas Trader Y has used a real leverage of 100 times. In terms of margin-based leverage the broker allowed both traders to trade up to a maximum leverage of 100:1. Given that the broker requires 1% margin, Y has leveraged his margin of $1, 000 to $100, 000 for each standard lot. This also means that he has used a real leverage of 100 which is calculated by taking $500, 000 divided by $5, 000. And so if he’d had bought only $100, 000 he would’ve used only 20 times real leverage and lost less money. It is real leverage which is dangerous.
This example has been developed to give you a better picture about the new rules of the CFTC. Indeed if the broker is required to reduce his margin to 50:1 our Trader Y would likewise be forced to use lower real leverage. This means that he would lose less if the trade goes against him. This is why on the 30th August 2010, the CFTC has finally decided to limit leverage for major currency pairs to 50:1. This decision by the CFTC came into force on 18th of October 2010.
The foreign exchange market is finally beginning to garner mainstream attention. The Bank of International Settlements estimates that the average daily volume in the fx market is around $4 trillion, which makes it by far the largest financial marketplace in the world. Surprisingly, however, many novice investors and traders have never even heard of this market. Until the late 1990′s, the only players allowed to execute trades in the foreign exchange market were investment banks, hedge funds, and very wealthy private …