The Forex market is one that 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 to currencies in a currency pair to make a profit from guessing the right direction, 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 being dragged in. It is not a game, these guys are not playing, people lose or make money here. You may see a currency pair moving aggressively to the upside and downside throughout a trading day, but 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, even though it is so huge. Over five trillion dollars are exchanging hands daily, making it the biggest financial market in the world. There are many entities that participate in this market, with the retail traders being part of the least representative and almost insignificant part. To have an idea about it, only around five percent of the money that are being exchanged on any given day belongs to the 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 even if 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 possible for Forex brokers to offer better and better conditions to the retail trader. A proper offering is one that considers 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, a closer look to this disclaimer, and you’ll see that not only deposited funds are 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 EURUSD worth of one thousand dollars. For this reason, the Forex trading industry, at least the one dedicated to the retail traders, is working on leverage.
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Leverage Means Risk
Forex trading accounts offered by brokers are leveraged accounts. It means that traders are moving more money that their trading account is showing. There are multiple leverage options to be chosen from, and, as a rule of thumb, the bigger the leverage, the bigger the risk. Therefore, we can 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 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 two hundred or four hundred times bigger. Therefore, trading on leverage means trading on borrowed money, and the bigger the leverage is, the bigger the amount borrowed. Hence, the bigger the risk or the exposure in a trading account. There are Forex brokers that offer leverage all the way up to a thousand and even a few thousand times the deposited money. This is extremely risky, as only a small move the market is making, and the funds in the trading account are depleted.
What is Normal Leverage 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 and probably the trader is not belonging to 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 for the account to be lost. But, this is a poor strategy for the broker as well, as its interest, if the broker is not a scam or crook, is to have the trader active as long as possible. This way, commissions, and fees are pouring in and the broker fulfills its purpose: to intermediate financial transactions in exchange for a commission. Unfortunately, not all brokers are doing that. However, only because higher leverage is available, it doesn’t mean one must accept it. You can choose, as a trader, the risk degree 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.
This means that there is no open position in the trading account, or that the trader is flat. Being flat, it implies all positions are squared. Depending on the size of the leverage, if the trader is opening a new trade, the amount that is going to remain available as free margin is going to be different. As an example, if an EURUSD one 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 trader will put a bigger “collateral” as a guarantee for its leveraged funds, the lower the leverage is. While at the first look, this may seem not to be in a trader’s favor, it 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 the 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 therefore traders “feel the need” to have more margin available for trading, to take “part of the action” at all costs. This is a deadly mistake for the long run, and, in time, retail traders will learn that patience and low risk are ingredients for successful trading. Unfortunately, this is a costly learning process for most of them.
Recommended Further Readings
- Forex Trading Sessions and Their Importance
– Explaining the differences between the three Forex trading sessions, what are their importance, ranking, etc. - Forex Brokers Types – ECN or STP?
– What is ECN, STP, how d- brokers deal with client’s orders, advantages, and disadvantages of the tw- types. - Benefits of Mobile Forex Trading
– Pros and Cons of mobile trading, highlighting the net benefits of it. - Explaining Commissions in Forex Trading
– What type of Forex trading accounts are subject to paying commissions, what does it means and is this a good or a bad thing?
Other Educational Materials
- Liquidity and leverage. Adrian, T., & Shin, H. S. (2010). Journal of financial intermediation, 19(3), 418-437.
- Leverage, investment, and firm growth. Lang, L., Ofek, E. and Stulz, R., 1996. Journal of financial Economics, 40(1), pp.3-29.
