RISK OF EXCESSIVE LEVERAGE
Leverage is a double-edged sword. While it has the potential to magnify a trader ’s gains, it certainly has the potential to magnify losses as well. In fact, the greater the leverage, the greater the risk. Let ’s take a look at an example. Both Trader A and Trader B open an account with a broker and start trading with a capital of USD10,000. Trader A uses leverage of 50:1 while Trader B uses leverage of 10:1. Both traders then decide to sell EUR/USD because the ongoing sovereign debt crisis is putting some pressure on the euro.
Trader A ’s total contract size is 100 × $10,000 = 1 million. This equals to 10 standard lots. Trader B ’s total contract size is 10 × $10,000 = $100,000. This equals to 1 standard lot. For EUR/USD, we learned that 1 pip equals USD10 for one standard lot. If the trade goes against them by 50 pips, both traders will incur these losses:
Trader A: ( 5 lots ) × ( 50 pips ) × ( $ 10 / pip ) = USD2,500
Trader B: ( 1 lot ) × ( 50 pips ) × ( $ 10 / pip ) = USD500
The USD2,500 loss represents 25% of Trader A ’s trading capital, but the USD500 loss represents just 5% of Trader B ’s trading capital. Take a look at the summary of two traders who trade with different leverage. In conclusion, while leverage has the potential to magnify your profits, it also has the power to amplify your losses. It cuts both ways. After the
global financial crisis of 2008 to 2010, U.S. regulators moved to regulate the forex industry there. On October 18, 2010, the National Futures Association passed rules to limit the amount of leverage retail forex brokers can provide. The rules limited leverage to 50:1 on major currencies and only 20:1 on minor currencies.
A pip is the smallest price movement in a currency pair. If the EUR/USD moves up from 1.3435 to 1.3436, this movement is called 1 pip. Similarly, if the same quote moves down from 1.3435 to 1.3434, the movement is also called 1 pip. Whenever the U.S. dollar appears as a counter currency, 1 pip earns the trader USD10 for one standard lot. Some forex brokers go one step further and quote prices to five decimal places. For such brokers, the EUR/USD quote could be seen as 1.34358.
It is important for us to take note that the fi fth decimal place is not called a pip but a pipette. Quotes that have the Japanese yen as the counter currency are displayed in three decimal places instead of two in these cases. Brokers provide retail traders with leverage to trade the forex market. Without leverage, a trader would need to pay out USD100,000 to trade one standard lot of currencies. With a 100:1 leverage, a trader would need to put up only 1/100th of the entire amount, or USD1,000. This amount is called margin.
Margin basically allows a trader to purchase a contract without the need to provide the full value of the contract. The higher the leverage employed, the smaller the margin required to trade one standard lot. Some brokers even offer leverage up to 500:1. This means traders need only USD200 to control USD100,000 worth of currencies. Leverage is a double-edged sword. Although it helps to magnify a trader ’s gains, it can also amplify a trader ’s losses. Hence, it is imperative that traders fully understand the pros and cons of leverage before deciding the appropriate amount of leverage to employ.