What is Leverage?

The Forex market has only recently been available to the average retail trader. Once the Internet started expanding so rapidly around the world, the industry exploded, in the sense that it became more and more viable to offer such a product to the retail market. When exchanging a currency against another one, or comparing two currencies in a currency pair to make a profit from guessing the right direction the price will move in, traders send an order to their brokerage houses. The order is executed by the broker, or routed to other liquidity providers in the interbank market for proper execution. The whole Forex market is huge, and rising by the day as more and more participants are dragged in. It is not a game, and these guys are not playing; people lose or make money here. When you see a currency pair moving aggressively to the upside and downside throughout a trading day, that is not the result of someone pushing some buttons, but the result of real people trading real money. The natural law of supply and demand reigns in the Forex market as well, despite its being so huge. Over 5 trillion dollars exchange hands daily, making it the biggest financial market in the world. There are many entities that participate in this market, with retail traders being one of the least representative groups, and an almost insignificant part. To get an idea about it, only around 5% of the money that is exchanged on any given day belongs to retail traders. The rest of it represents institutional investors, hedge funds, commercial banks, central banks, brokers, institutional investors … and the list can go on. What I’m trying to say is that although the retail size of the Forex trading market is so small, it means it has a lot of room to grow in the future. The last decade or so saw encouraging technological developments that made it possible for Forex brokers to offer better and better conditions to the retail trader. A proper offering is one that entails less risk for both the trader and the broker. After all, the broker is not only an intermediary, but also a partner in the whole process.

Defining Risk in the Forex market

Every Forex broker has on its homepage a risk disclaimer, stating what it is only obvious: Capital is at risk. However, take a closer look at this disclaimer, and you’ll see that not only are deposited funds at risk, but even more. This requires a bit of an explanation. The interbank market is somehow restricted when it comes to the conditions to be met to take part in trading. One cannot simply go and buy EUR/USD to the value of 1,000 dollars. For this reason, the Forex trading industry – at least the section dedicated to the retail traders – works on leverage.

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Leverage Means Risk.

Forex trading accounts offered by brokers are leveraged accounts. This means that traders move more money than their trading account shows. There are multiple leverage options to be chosen from, and as a rule of thumb, the higher the leverage, the higher the risk. We can therefore safely say that leverage represents the risk traders take. Leverage is presented in the following way: A typical risk for a trading account has a leverage of between 1:200 and 1:400. This means that for every dollar/euro/pound, etc., in a trading account, the amount that is moved on the real market is 200 or 400 times greater. So trading on leverage means trading on borrowed money, and the higher the leverage is, the higher the amount borrowed, and hence the bigger the risk or exposure in a trading account. There are Forex brokers that offer leverage all the way up to 1,000 and even a few thousand times the deposited money. This is extremely risky, as the market only needs to make a small move for the funds in the trading account to be depleted.

What Normal Leverage is, and How to Mitigate Risk

As mentioned above, at least for the Forex market, a normal leverage is between 1:200 and 1:400. Anything above is considered riskier and needs to be avoided, while anything below means that the trader probably does not belong in the retail trading category anymore. Of course, brokers will try to sell you the trading account with the biggest leverage possible, as this increases the chances of the account being lost. However, this is a poor strategy for the broker as well, as unless the broker is a scammer or a crook, its interest is to have the trader active for as long as possible. In this way, commissions and fees pour in, and the broker fulfils its purpose: to intermediate financial transactions in exchange for a commission. Unfortunately, not all brokers do that, but just because higher leverage is available, it doesn’t mean one must accept it. You can choose, as a trader, the degree of risk you feel comfortable with taking. As a rule of thumb, the bigger the leverage, the more margin is available in the trading account. Look at the image below. The balance in the trading account, equity, and free margin are equal.
what is leverage - 1
This means that there is no open position in the trading account, or that the trader is flat. Being flat, it implies that all positions are squared. Depending on the size of the leverage, if the trader opens a new trade, the amount that is going to remain available as free margin is going to be different. As an example, if a EUR/USD 1-lot trade is taken on a 1:200 leveraged account, the free margin available for other trades will be smaller than in a 1:400 account. In financial terms, the lower the leverage is, the bigger “collateral” the trader will put as a guarantee for its leveraged funds. While at first glance this may seem not to be in a trader’s favour, it actually is. If something goes wrong (as so many times it does!) when trading the Forex market, there will still be plenty of free margin to take another trade. On the other hand, if leverage is too elevated, even small moves can wipe out a trading account. In the end, managing risk is all that trading is about. The psychological component is important as well, and so traders feel the need to have more margin available for trading, or to be “part of the action” at all costs. This is a deadly mistake in the long run, though, and in time retail traders learn that patience and low risk are ingredients for successful trading. Unfortunately, this is a costly learning process for most of them.

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