Forex Trading: How Leverage Really Works Against You
By: Hillel Fuld
The Forex market is an ideal trading arena for making serious profits. However, with its potential comes a danger just as great, if not greater. Forex, as a whole, is filled with misconceptions of what is right and wrong when it comes to trading. Many traders are misled by false information being distributed by uneducated “experts” and more often than not, by the Forex brokers themselves.
To just name a few areas in which Forex traders go wrong, there is the whole concept that Forex can provide you with an immediate profit of tremendous proportions. This is of course completely false, and can even be the complete opposite of the actual reality of Forex trading. The statistics are out there, depending on who you ask, anywhere between 80% and 90% of all trades in the Forex market end up with losses. So, in essence, the Forex market can provide you with immediate losses of tremendous proportions, and not profits.
Another common misconception in Forex is that you can jump in to the biggest market in the world without preparing yourself both mentally through comprehensive research of the market, physically, by making sure you have sufficient capital to trade Forex, and emotionally, by acquiring a deep knowledge of yourself and what kind of trader you are before risking your money.
It is true that there is lots of money to be made in Forex, but without spending sufficient time trading a demo and learning the industry, chances are you will not be seeing any of that money.
What is Leverage? What is Margin?
Another common misconception that many traders have is that in order to reach the true potential of the Forex market, you need to trade with a high leverage. Before we go into this falsehood, and why it is so detrimental to your success as a trader, let's spend a few minutes understanding the basic concept of leverage and margin in the Forex market.
A few definitions of Leverage:
- “The mechanical power or advantage gained through using a lever”
- “The degree to which an investor or business is utilizing borrowed money.”
- “The use of credit or borrowed funds to improve one's speculative capacity and increase the rate of return from an investment, as in buying securities on margin.”
In our own words, leverage is the ability to use whatever funds you have to increase the amount you are allowed to borrow from an external body. The capital that you bring to the table is referred to as margin.
To just clarify these two basic terms, when you buy a house and cannot afford to pay for it all up front, the bank checks your salary statements and sees that you are financially capable of paying monthly installments. The bank is therefore willing to allow you to leverage your salary and loan you the money you need for the house. Margin and leverage in the Forex market is very similar.
A Look at High Leverage
When people (I am personally guilty of this too) discuss the advantages of Forex trading, one of the first things they mention is its high leverage. When trading Forex, you can open positions worth hundreds of thousands of dollars with a capital of a two hundred dollars or even less.
It is true that this draws many people to trade Forex, but if those people spent a few minutes really thinking about this concept and what they are essentially doing with their money, they might be a little more hesitant to trade with leverage of 100:1, 200:1, and even 400:1. Leverage is actually one of the biggest Forex dangers.
Someone once compared Forex leverage trading to driving a car. Anyone who has driven a car knows that when you drive at a speed of 60 KM/h or 200 KM/h, the turns of the steering wheel have a totally different affect. If you are driving at a low speed and accidentally turn the wheel slightly, the car will shift very slightly, and give you the opportunity to correct your mistake. If, however, you are driving at very high speeds and make that same mistake, the consequences will be deadly. The car will completely change directions and you will have much less time if any at all to fix the situation.
In Forex trading, leverage equals high speed. The higher the leverage, the faster you are driving. Therefore, even the smallest change in the market, can bring irreversible damage to your account. If however, you drive slowly and carefully, you might reach your destination a few minutes later, but at least you will get there alive. That is, if you trade with low or no leverage, you might make smaller profits, but no one trade will bring a complete closure of your trading account. You will always have the option to fix the situation with another trade.
Beware of Marketing Ploys
The problem many traders face when beginning to trade Forex is the marketing abilities of the Forex brokers. One of the first things you will encounter when viewing the standard broker's website is how incredibly high their leverage is. Did you ever thing why it is that if they are lending you the money in the same way the bank is, they do it with no Forex interest? Are they doing it out of the kindness of their hearts or do they know something about that money that you don't? Think about that.
While most brokers, through their marketing teams, try to lure traders into trading with as high a leverage as possible, it should be your goal, as a trader, to trade with as low a leverage as possible. Just like you would not borrow money from the bank to buy a house, unless you really had to, and you would try to put down as much of your own capital as possible, you should trade Forex with as little leverage as possible.
One of the primary characteristics of the Forex market is its volatility. Leverage simply makes that already high volatility even higher, thereby increasing your risk by a lot. The important thing to remember about trading with no leverage is that the only way to lose all your money is if that currency loses all its value. Obviously, the dollar or the euro will always be worth something, so trading with no leverage is a pretty safe bet.
Simple math dictates that if you trade 40 trades a month at a 20:1 leverage and a 5 pip spread, you are talking about a $4,000 expense before even losing one trade. When you apply that to a trader that loses 35% of his trades, which is a pretty good track record, he will end up losing 14% of his account. Using this optimistic scenario, after an extended period of time, a very good trader will break even, and most traders will end up losing, maybe not right away, but in the long run. The reason for this is that while the leverage is offering potential for gains, it is also slowly draining your trading account.
Besides playing a very negative role when it comes to your capital, leverage also causes you to lose focus and remove your eyes from the developments of the market and causes you to obsess and focus on the volatility and developments of your personal account. You end up analyzing your huge demo profits and coming to very incorrect conclusions about your strategy. If you were to trade with no leverage, you can go back and assess your accomplishments, and you can be sure they are based on your trading tactics, not on your leverage. Using high leverage can lead not only to a draining of your account, it can also rob you of your ability to trade sensibly and logically.
In conclusion, high Forex leverage has become a major buzzword in the world of Forex trading. The reason for this is not because it is what is best for the Forex trader. On the contrary, high leverage is being pushed down traders' throats by the marketing teams of the various brokers. The reason they are interested in you trading with high leverage is all the reasons we mentioned above, but mainly because your chances of coming out on top when trading with high leverage are very low, and at the end of the day, most brokers, at least the market makers amongst them are the ones trading against you, and are profiting from your losses.