How Leverage Really Works Against You

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1 Forex Trading: How Leverage Really Works Against You By: Hillel Fuld Reviewed and recommended by Rita Lasker 2012

2 Introduction: 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.

3 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. 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.

4 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. 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 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

5 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.

6 Part 1. Calculating Leverage The concept of leverage is really quite simple, but its true meaning often becomes lost in the mountain of marketing-speak most forex brokers dish out at us traders. The misconceptions always arise as a result of the interchangeable usage of the words margin and leverage. These two concepts are related, but are in fact not interchangeable except in the most extreme (and suicidal) case where a trader decides to use the maximum leverage available to him under the broker s house rules. Margin - The amount of collateral a customer deposits with a broker when borrowing from the broker to buy securities. This is your account balance when you first open your account. Leverage* - The use of credit or borrowed funds to increase one's speculative capacity and increase the rate of return from an investment, as in buying securities on margin, although it can also increase the rate of loss by the same factor. Your leverage depends on the size of the trades you make relative to your account equity, and nothing else, as long as you don t surpass the maximum leverage the broker allows. This value is normally displayed as a DEBT:EQUITY ratio. Margin requirement expressed as a percentage, the margin requirement is set by your broker to protect itself against traders using too much leverage, or in other words, against traders borrowing more than their collateral would support according to the broker s risk management parameters. * This definition applies to trading accounts. The more general definition of financial leverage is somewhat more complicated, but luckily it is unnecessary for our current purposes. So when a broker s marketing team says their margin requirement is 1%, it means that they require 1% of your trade size in order to lend you the amount you need for the trade. For example if you are trading $100,000 position size, then the broker

7 requires $1,000 (1%) of your margin in order to make the loan. As I stated before, this number generally does not vary unless you specifically change the deal with your broker. Furthermore, in this example we know what the margin requirement is, but we don t yet have enough information to calculate leverage, because we don t know what our account equity is (more about this later). Your broker would normally quote that as 100:1 leverage, which is not entirely accurate since our actual leverage also depends on our account equity. What they are actually saying is that your maximum leverage, based on their margin requirement, would be 100:1. How much of that leverage you actually use is entirely up to you, as long as you don t surpass this maximum. To recap then, the major difference is that the margin requirement is set by your broker, which determines your maximum leverage. How much of that available leverage you use in your trades is entirely your choice. Your broker does not set your leverage. They just set the maximum that you can use. A responsible trader generally never has to worry about this, as the leverage s/he uses is far below the maximum allowed by the broker. Whether a broker s marketing guys offer you 400:1 leverage or 50:1 leverage should not generally make any difference. Let s see first how to calculate leverage, and then why responsible traders never over-use it. Part 2. HOW TO CALCULATE A TRUE LEVERAGE The term true leverage has been in use recently to differentiate it from the maximum leverage that brokers use in their marketing efforts. A few years ago, the word leverage would have been sufficient to describe what we are calculating, but retail forex marketing lingo has changed the traditional use of the word. As we mentioned before, leverage in the financial markets is the DEBT:EQUITY ratio, so we need to calculate our debt and our equity (duh). Equity is very easy to calculate: E=B+P where E = Equity (the quantity we are trying to calculate) B = Balance P = Profit on open positions (negative if open positions are in the red)

8 Debt is a little more complicated: * Where D = Debt (the quantity we are trying to calculate) T = Trade size (in units of the base currency) C B = Base currency C A = Account currency * Please note that the equation uses forex notation, and not true mathematical notation. In mathematical notation, EUR/USD would be displayed as USD/EUR because it denotes a ratio of Dollars per Euro. If you would like to use mathematical notation, currency pairs should be inverted. So leverage, L, is calculated as follows: If that looks complicated, please don t worry, it isn t. Let s work through an example: Say you have a $10,000 USD-denominated account and you wish to trade 1 mini lot of EUR/USD at : T = 10,000 (1 mini lot) EUR/USD = B = $10,000 P = 0 (we don t have any trades open so the account equity is equal to the account balance) Substituting in the values: These calculations ignore the spread, which would affect P. Equations for that become more complicated because we have to include the pip value. In this example, it

9 would be simple, but for pairs where the quote currency is not the same as the account currency, our leverage equation would be significantly more complex. This omission only becomes significant for large values of P relative to B (positive or negative) which should not generally occur in a properly managed forex account. Please note also that this formula works equally well for pairs which do not involve the account currency, but we have to be careful to make the right substitution, and we need a bit of extra information. For example, say we are trading 1 mini lot of GBP/JPY = and GBP/USD = on the same $10,000 account: For trading such pairs, we need to know the current rate of the base currency against the account currency, and we don t need the rate for the actual currency we are trading: It also needs to be noted that the actual leverage used varies during the lifetime of any open trade. As currency rates move, they affect the leverage equation by affecting P as they either move in your favor or against you, and they also affect C b /C a. Conclusion If you learn the proper way to calculate your leverage you will master Forex. If you have the correct Lot Size that corresponds with the leverage you will secure your deposit. It is the key of the profitable trades.

10 If you have any questions, please feel free to ask our support team by sending an to: We will do our best to help you. Yours, Rita Lasker & Green Forex Group. Any additional information: Contact Information: ALL Green Forex products:

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