Atish Patel – FX Trader, Trainer & Support Coach for Samuel & Co Traders
Trading the FX market can initially be quite overwhelming with the huge amount of information available online. With so much room for interpretation, I fully understand the difficulties one may come across when trying to build a strategy and be consistent in the markets. Going forward I aim to simplify some principles surrounding the FX market starting with some basics. Please feel free to comment and ask any questions and I’ll be sure to answer them!
… We’re going to keep this nice and simple!
One of the reasons why so many people are attracted to trading forex compared to other financial instruments is that with forex, you can usually get much higher leverage than you would with stocks for example. While many traders have heard of the word “leverage,” few actually know what it means, and the impact leverage can have on your trades.
Leverage involves borrowing a certain amount of the money needed to invest in something. In the case of forex, that money is usually borrowed from a broker. Forex trading does offer high leverage in the sense that for an initial margin requirement, a trader can build up and control a huge amount of money.
Leverage is the ability to use something small to control something big. When FX trading, it means you can have a small amount of capital in your account controlling a larger amount in the market.
The obvious advantage of using leverage is that you can make a considerable amount of money with only a limited amount of capital. The problem is that you can also lose a considerable amount of money trading with leverage. It all depends on how wisely you use it and how conservative your risk management is.
Leverage is usually given in a fixed amount that can vary with different brokers. Each broker gives out leverage based on their rules and regulations. The amounts are typically 50:1, 100:1, 200:1 and 400:1.
As an example, 50:1 leverage means that for every $1 you have in your account you can place a trade worth $50. As an example, if you deposited $500, you would be able to trade amounts up to $25,000 on the market using 50:1 leverage. It’s not that you should be trading the full $25,000, but you would have the ability to trade up to that amount.
Similarly, 100:1 leverage means that for every $1 you have in your account, you can place a trade worth $100. This is a typical amount of leverage offered on a standard lot account. The typical $2000 deposit for a standard account would give you the ability to control $200,000.
Let’s take a look an example with some numbers:
If the leverage of your account is a massive 500:1, this means you can trade up to 500 times the equivalent amount of base currency you have in your account.
Let’s take two traders, Trader X & Trader Y, who both have an account balance of $10,000.
Trader X has a leverage of 50:1 and Trader Y has a leverage of 5:1. Take a look at the hugely different effects on their accounts if they were to both have a 100 pip loss.
Trader Y only lost $500 of his capital, while Trader X lost $5,000. In summary, using a conservative leverage, you have a greater chance of long-term success.
ESMA Leverage Restrictions for Retail Traders
The European Securities Markets Authority (ESMA) is an independent EU Authority that helps safeguard the stability of the European Union’s financial system by improving the protection of investors. From 30th July 2018 a new ESMA Regulation can into action with a view to better protect retail clients trading leveraged products.
This involved a restriction to 30:1 leverage for major currency pairs and 20:1 leverage for non-major currency pairs. These restrictions act as protection for retail traders with little knowledge who can get tempted to trade with huge levels of leverage with little or no experience.
For the most part, professional traders trade with low leverage. Keeping your leverage low protects your capital when you make trading mistakes and keeps your returns more consistent. Many professionals will use leverage amounts like 10:1 or 20:1. It’s possible to trade with that type of leverage regardless of what the broker offers you. You will, however, have to deposit more money and make fewer trades.
While leverage can increase the potential return on investments, it also has the capability to increase potential losses as well, so it’s imperative that you think carefully about the amount of leverage you want on your trading account. No matter what your style, always remember, just because the leverage is there does not mean you have to use it. In general, the less leverage you use, the better. It takes the experience to know really when to use leverage and when not to. Staying cautious will keep you in the game for the long run.