Leverage – A Controversial Issue Among Traders

margin trading

With the leverage effect, you can move a lot more money than you have deposited in the margin.

Leverage is a controversial issue among foreign exchange and cryptocurrency traders. In 2018, ESMA drastically reduced the leverage for the classic retail trader with its new regulatory rules while Deribit, a Bitcoin broker, increased the leverage up to one hundred. For some, leverage is a blessing, for others a curse. However, when used correctly by a professional, it can be an adequate way to get the most out of your trades with a minimum of risk.

Some traders may know the term leverage from derivatives trading. Also in the Federal Government they speak more frequently of “leveraging” certain investment packages for the euro zone, which in this case means nothing else than that the taxpayer as guarantor for credits steps in, in order to guarantee a certain sum, which is by far higher than the actually deposited money amount.

Bitcoin margin tradingTrading beginners are advised not to “leverage” their trades immediately, even if a leverage of 1:20 or 1:100 seems tempting at first glance. Profitable traders, for example, can generate an extremely high return with a leverage of 1:100, as is possible on BitMEX or Deribit with little capital investment. For beginners and inexperienced traders, however, such a lever is very dangerous. Here on bitcointradingsites.net there is a comprehensive list of the cryptocurrency brokers that allow margin trading.

A total loss is as good as certain, especially with very small accounts. Basically, leverage is nothing more than a broker’s trading credit. For many brokers, the leverage varies from instrument to instrument. While with the Forex broker eToro, for example, we get a leverage of 1:400 on the EURUSD, they only grant a leverage of 1:6 on the Bitcoin. This happens for reasons of risk diversification, to which the broker must also submit.

A high leverage therefore also means a high risk for the broker, as he has to finance the positions with borrowed funds. Financial instruments such as the Bitcoin, for which Futures have only recently been available, represent a higher risk for the broker, as it is difficult for him to hedge on the primary market.

High Leverage

In general, 2018 has not been a pleasant year for traders. Not only regulators and taxes make life difficult for traders and trading coaches, but also the completely absurd DSGVO, according to which basically every self-employed person now stands with one leg in prison. The over-regulation mania of the EU currently knows no borders, so that many are thinking of leaving the EU. Leverage reduction is still the lesser evil, because there are simple alternatives. Which many trading beginners also do not want to admit:

Of course there are still micro- and mini lots, so that you can learn and practice trading with a small account and a reasonable risk of 1 – 3% per trade. Only the gigantically leveraged gambler trades don’t really work with a leverage of 1:30 anymore. If you still want to trade a high leverage, you can do the following:

You can take the opportunity to switch to an account on BitMEX. There you can trade with a small amount of $5 or $10 to practice margin trading without the risk of a big loss as a beginner.That way you get an account with a non-European broker: The ESMA regulation only applies within the EU. If you open an account with a broker outside the EU, you are not subject to ESMA regulation. But beware: some offshore brokers engage in dubious business practices and you do not enjoy any legal certainty if the broker is registered in the Cayman Islands or the Bahamas. Whether such a broker pays out the earned money in the end is always a stroke of luck.

Also read the ESMA discussion on the babypips.com forum.

Leverage in Certificate Trading

On the stock exchange, we are also familiar with the leverage effect in certificate trading or in options trading. Below is an example:

Example

We buy a leverage certificate, for example a factor certificate on the German DAX share index. Since we are betting on rising prices, we buy a long certificate. If we were to speculate on falling prices, a short certificate would be our choice. To multiply our profits, issuers offer certificates with different levers, mostly with a leverage of two, four, six, or eight, depending on the trader’s risk affinity or aversion. So if we buy a long certificate with a factor of eight on the DAX and the Index actually rises by three percent the next day, we have not only made 3% profit with our certificate, but 24% (3 x 8).

A certificate that we bought the day before for 10 USD would therefore already have a value of 12.40 USD at the end of the next day and not just 10.30 USD, as with an unleveraged note. However, if the price runs against us and the DAX loses 3% contrary to our expectations, we have to accept a 24% discount on the certificate with a leverage of 8%.

Futures

In contrast to stock trading, no payment is due as soon as the forward contract is entered into. Not yet. However, in order to ensure that the trader can meet the obligation arising from the contractual relationship of the futures, he deposits a small security deposit, the margin. This means that the trader does not have to raise the entire sum for the speculation, but only a small part of it. If the position falls below the margin provided during trading, it is automatically closed by the broker. With futures brokers, this process is usually associated with a fee. The famous margin call is then reached.

In the past, when trading was even more frequent by phone than by internet, a call from the broker came at this moment with the request for additional payment, since otherwise the account is closed and all positions are closed. This ensures that the trader is not in debt and that there are no additional payment obligations. While the so-called margin call obligation for the retail trader in the Forex and CFD area was recently lifted by ESMA and BaFin (i.e. the account can fall to a maximum of zero), it still exists in futures trading!

If, for example, the trader is positioned long in an index and the prices suddenly crash due to a political event (e.g. terrorist attack, war, etc.), there are limit ups or downs, trading is suspended for a few days and only opens a thousand points lower a few days later, then exorbitant losses can occur for the futures trader, which are no longer covered by the margin. The StopLoss has no effect in this case, as it is only executed again at the next available price. The advantage of the crypto market in that case is that they are usually open 24/7, so trading platforms like BitMEX or Deribit should never be closed for several days due to any event.

As long as the Forex market is closed, however, there are no available prices. The trader then has to shoot at the broker, so to speak, until his account is back to zero. In such an, albeit rare, emergency, the trader is well advised to hedge in a closely correlated market in the event of such an event. In the case of a terrorist attack in the USA and a simultaneous long position in a US index, if trading is closed, a short position in the DAX or another small cap index would be offered, for example, to compensate for the losses – provided that this exchange is still open. Every trader is well advised to draw up such an “emergency plan” before entering into real money trading with large sums of money. In such situations, the trader must become creative and, if necessary, switch to other products in order to hedge against losses on the futures market, for example with short certificates from an issuer (e.g. a bank).

Foreign Exchange Leverage

stock exchangeThe leverage system is also used in private foreign exchange trading in order not to endanger the financial integrity of the trader. In order to participate in Forex trading as a retail trader, you do not have to transfer the entire amount of the traded amount to the broker’s account. It is therefore sufficient to have a fraction of it (the margin or initial deposit required by the broker) on the account. However, the required deposit in forex trading is usually much lower than in futures and options trading.

This is why foreign exchange trading has become so popular with small investors. The advantage of this is that the loss is limited to the initial deposit (usually between 25 and 1000 dollars or euros), while at the same time you have almost infinite chances of winning. For example, you can move 400 times your stake with a lever of 1:400! If the price ever falls below the amount covered by the minimum deposit, the Forex broker automatically closes the trade, currently at 50% of the required margin for the trade.

Experienced traders know, however, that to maximize profit, at least if you want to make a living from trading, you should go higher. Because it is always necessary to survive a longer draw down which only works if the account is sufficiently covered with capital. Sufficient start capital of a seriously ambitious trader career would be a minimum of 10k USD, better still 20k USD. In all other cases, in which the account is undercapitalized with a few hundred USD, you are usually taken out of the trade too early by the Stop Loss and make continuous losses. Therefore as a beginner you should save rather a few months and practice with the demo account, in order to enter then directly with 1000 euro, instead of burning 10 times 100 euro unnecessarily.

Margin

Many Forex brokers require a security deposit of between one and four percent of the traded amount. For a standard lot (consisting of 100,000 units of one currency) the margin is 1000 to 4000 units of the base currency. You should not forget that with a standard lot in EURUSD each pip (the 4th decimal place of a rate) amounts to as much as 10 USD! So small price movements are sufficient to erase such an undercapitalized or leveraged account if you are wrongly positioned and the price runs against you.

For a so-called mini lot, which some brokers have on offer and which is often noticed by beginners (10000 units of the base currency), it is only 100 to 400 units of the base currency. In order to hold positions over the weekend, some brokers require a higher margin, as there is little liquidity in the forex market at this time and therefore a higher risk. When trading from a small lot, the value per pip is only 1 USD. For beginners with small accounts, it is best to start trading micro lots. There the value of a pip is only 10 cents and thus allows an appropriate risk and money management for small accounts.

In order to move 100,000 units of a currency as a private trader on the foreign exchange market, you only need an account balance of at least 1,000 units of the base currency, for example 1000 euros, with a margin of one percent (usually specified as 1:100). From August 2018, it will be 3,333 euros for 1 lot in EURUSD for retail customers. Nothing will change for professionals. This amount is transferred from Trader to the Broker’s account by bank transfer or Paypal when the account is opened, the Broker tops up the rest. This effect is then referred to as the leverage effect.

With only 1.000 USD on the account, 100.000 USD can be moved in the forex market in this example, i.e. one hundred times the amount actually deposited!

To learn more about lots also read this article on the Balance.com.

Example

The leverage effect is best illustrated by a small example: Assuming that a trader deposits only the minimum deposit (1%) of the traded amount. If he trades a standard lot (100,000 units of the base currency, or 100,000 USD for a trade in USD/EUR), he only needs an account balance of 1,000 USD. These 1,000 USD are now constantly offset against the profits and losses from the 100,000 USD position. If the trader enters a long trade in USDEUR and makes a profit of 40 pips, he can be happy about 400 USD, i.e. 40% yield. However, if he is wrong with his assessment, his account will be reduced by 40%. His new account balance then amounts to only 600 USD.

Depending on the exchange rate, a movement of one percent in the exchange rate is often enough to double the account – or to destroy it completely. Therefore a trader should speculate only with money, which he can afford to lose and an appropriate position size select. Whole lots should only be traded by professionals with very large accounts, especially as financing costs such as spreads, commissions and swap fees are to be expected.

In order to avoid the total loss of the invested capital, you should definitely set a stop loss that closes the position if the trade does not run in the desired direction and only risk 1 or 2% of your capital for a trade at all. Alternatively, you can hedge the position, i.e. open a trade in the opposite direction. With this strategy you can increase your margin and at the same time make a profit with the counter-movement. Of course, you have to close the hedged position in time as soon as the trade is back in the desired direction.

Another Example For Illustration

With an account of 25 USD a position over 100 USD is entered. This means that 100 USD is traded in the market and 25 USD is deposited in the account as security. If the traded position is now revalued by 25 USD, this corresponds to a gain of 25 percent. Since there is only $25 security in the account, the account balance doubles – even though the position only moved by 25%. The same effect, however, also works the other way round: if a loss of 25% of the traded position occurs, the account would be empty. The leverage that affects the account balance is 1:4 in this example.

Security and leverage are therefore directly related. Unfortunately, many beginners in forex trading are tempted by the high profit prospects through a high leverage effect, which can be expected if the leverage is fully exploited. If the account actually has only the minimum security deposit or little more, there are in fact high percentage profit opportunities, as illustrated above. However, the same also applies to the risk, a rapid total loss is not excluded. On the other hand, the leverage also makes forex trading interesting for many, as even the “little man” with a relatively low deposit can earn a considerable fortune in a short period of time.

In fact, however, it is only possible to trade profitably in the long term by not fully exploiting the leverage and adjusting the position size to your account. Everything else runs under the heading of senseless gambling! In order not to endanger his deposit unnecessarily, the trader should keep losses small and end these trades quickly, while he lets profitable trades run long to savor the trend and leverage of. Such entries are realized with tight stops and skillful chart analysis.

Lot

Although the height of the lever can be specified when opening an account, traders have the option of “fine tuning” by selecting a lot size appropriate to their account size. You can choose between Standard Lot (100k units), Mini Lot (10k units) and Micro Lot (1000 units). In Metatrader 4 you select the pilot size in the input mask when placing an order:

Lot Size

The trader can “fine-tune” his lever by adjusting the corresponding solder size. With microlots, even beginners can learn and practice trading in the low single-digit Euro range. To open a micro lot you only need a minimum deposit of 30 USD.

As a beginner, you should make sure that you trade on small accounts with a balance of up to 1000 USD exclusively in the micro lot range (0.01 lot). With growing experience and growing account size to 2000 USD and more you can then switch to trading with mini lots to make bigger profits. If you trade with micro lots, the movement of one pip in the market corresponds to 10 Dollar Cents, per mini pilot it is 1 USD per pip and if you open a whole lot, each pip moves 10 USD. If a beginner with little experience in forex trading and a small account trades the whole lot, a few pips of movement are enough to eliminate the whole account.

Practical Application

These explanations about the right leverage and position sizes will be quite theoretical for the trading beginner. Therefore, the best thing to do is to set up a non-binding demo account with enough play money to get used to using different position and lot sizes. Load your play money account with 50k USD and open a position in USDEUR with 1 lot, 0.1 lot and 0.01 lot. Watch what happens when the rate moves. So you can quickly calculate your risk and see live how powerful the leverage is used in trading.

RISK WARNING: Forex, futures, Cryptocurrency and CFD trading on margin involves a high level of risk and is therefore not suitable for every investor. All leveraged financial products carry a high risk for your capital. Trading such financial products can cause you to lose your entire deposit. Before you trade, you should carefully consider your investment objectives, financial circumstances, needs, experience and expertise. The content of this website should not be construed as personal investment advice. By trading and speculating in foreign exchange, you may suffer some or all of the loss of your deposited funds and should not speculate with capital that you cannot afford to lose. Be aware of all the risks associated with foreign exchange trading.