The Truth About Leverage

The main reason so many amateur forex traders fail is because they are consumed by the glamour of leverage. "Get rich quickly with just a few thousand dollars! Low margin! Leverage up to 400:1...", claim the market makers so intently. But what is the truth about leverage and does it help or hinder forex traders?


What is leverage?


Leverage/trading on margin, is a way of boosting your potential profits (as well as your losses) by means of a marginal balance as collateral. Basically, if you only have $1000, you can trade a $100 000 lot by using leverage, the $1000 being your margin. So in this instance, your leverage is 100:1 and your margin is 1% of the currency lot that you're purchasing. It's as if the market maker is lending you the money in order to help you add a couple of zeros to your profits. So what's in it for the market maker? Well, they're encouraging you to make more trades and the more trades you make, the more money they make because they take a small cut of every trade that you enter into. Therefore when you enter into a trade, you'll immediately open with a negative unrealized profit/loss balance.

The leverage set is dependent on the market maker, ranging anywhere from 50:1 up to an astonishing 400:1. Because the forex market is not as volatile as say the stock market, market makers can afford to make this loan to its traders at no risk to themselves. In any case, the market maker automatically liquidates any open positions you may have, in the event of your margin balance depleting beneath their required level.


The Beauty Of Leverage


This is an example of the power of leverage:

If you decide that the dollar is trading higher than usual to the franc, you might then decide to sell dollars, purchasing francs. If you have $10 000 and the market is trading at USD/CHF 1.3200, your trade would look like this:

$1000 x 1.3200 = 1 320 CHF

Assuming you're trading over a mid-term period (suggested - I will touch on longer term trading at a later date), if the market moves lower as you predicted, to say 1.2700, and you repurchase your dollars, it would look like this:

1320 CHF / 1.2700 = $1 039.37

So your profit in dollars would be $1039.37 - $1000 = $39.37

Now if you had used 100:1 leverage (sold $100 000) it would look like this:

$100 000 x 1.3200 = 132 000 CHF

The market moves to 1.2700, and you repurchase your dollars:

132 000 CHF / 1.2700 = $103 937

So your profit in dollars would be $103 937 - $100 000 = $3 937


In summation, if you had used leverage, you would have made $3 897.63 more profit than if you had just used the money that you had. That's an enormous difference, and this attraction is what the market makers focus on in their marketing campaigns. What they don't stress is that leverage works both ways.


The Dark Side Of Leverage


There are two sides to the coin of leverage. If you flip it on the right side, a cash flow problem would be the least of your worries. But flip it on the wrong side, even just once in some cases, and that could well mark the end of your trading career. Leverage is one of the pivotal reasons why 90% of all day traders fail. While leverage is an excellent way of magnifying your profits, first off, you have to know how to make profitable trades. And unless you have a degree in macroeconomics or are thoroughly acquainted with the forex market and its players, chances are, your failure is imminent. By the way, you may be a Fibonacci fanatic, but honestly, technical trading alone will not save you (I will touch on this as well). In any case, technical indicators were originally created to trade stocks and the like on centralized exchanges, not the exchange of foreign currency. It is indeed in a good trader's interest to make sensible, low geared trades. I would suggest that you do not exceed a leverage of 4:1.



Let me show you the results of steady, low geared trading, if every trade you made was a loss.




As shown above, with low gearing, 14 losing trades were required to reach a 50% deficit of your initial margin as opposed to 4 trades when using high gearing.


Don't Gamble


Respect the power of leverage. Ignore the dazzling advertisements. Do not consistently enter trades with high leverage, or your trading career will undoubtedly be over before it's begun. I can guarantee that the experienced, successful trader does not use high leverage, I certainly do not. If you're in doubt, read Roger Lowenstein's 'When Genius Failed'. This non-fictional story perfectly illustrates the overwhelming effects of high gearing, even when used by the most brilliant minds in the forex world. If you have $10 000 and are thinking of using high leverage, rather take that money to a casino - you will have as much chance of making money there as you do on the forex market.