Leverage: The Trader’s Best Bad Friend

Trading Forex is a game of inches. Price movements between currencies in short-term trades are too small to be measured in percentage points. Instead, they are routinely measured in minute fractions of a percentage point. Taken on their own, they aren’t worth a trader’s time and effort, unless the trader happens to have relatively vast amounts of money to play with. It almost certainly takes a greater amount of cash available to invest than the average middle-to-affluent investor.

That’s where leverage, or what the Brits call “gearing” comes in.

Leverage is simply borrowed money, used to invest.

Gearing, leverage

“Gearing up” means you can move a lot of wheel with a small pedal movement. Forex leverage works the same way.

A Simple Example

Here’s how it works, in a very simplified nutshell:

Here are two farmers – the first farmer is unleveraged, the second uses leverage.

Farmer 1, the unleveraged, has $1,000 to buy a cow. You buy a cow, paying cash. The cow gives two gallons of milk every day. He can sell those two gallons of milk for a dollar. He therefore makes 365 per year from milk, disregarding feed/grazing costs and milking labor. As a result, the cow breaks even within just under three years. If the cow dies unexpectedly, the most he is out is $1,000.

Farmer 2 employs leverage. Like Farmer 1, he has $1,000, which he would like to invest in dairy cows. He bids on a herd of 10 cows, putting up $1,000 of his own money and borrowing $9,000 from the bank. But instead of yielding $1 per day in milk, his herd yields $10 per day in income. At that rate, he makes up his entire $1,000 purchase price in just over three months. That’s three months, not three years.

After six months, he’s recovered enough in milk income to cover his own investment… and buy a bull. What a country!

Cow

If you borrow money to buy more cows, you can keep all the milk!

But his risks are greater, too. If an outbreak of hoof and mouth disease or mad cow disease forces him to slaughter his herd, and they are useless for meat production, he isn’t just out his $1,000 investment. He’s also out the $9,000 he owes to the bank!

The bank didn’t take an equity stake in the herd. They don’t expect a share of the milk proceeds or any upside from capital gains from any increase in the price of the cows. They just want – and are entitled to – their money back, plus interest.

That’s the point of lending: They want their capital to be safe, so you agree to pay them back, with interest, whether or not you make money with the cows. If you don’t pay them, they are entitled to sue you for the unpaid balance, plus attorneys’ fees.

So leverage, then, doesn’t just increase potential rewards. It also increases risk as well: When you increase leverage, you introduce the chance of losing more than you even have invested.

Other Costs

The cow example above, of course, is very simplified. It costs money to do business, and it costs money to employ leverage. Money has a cost: You must pay interest for the use of other people’s money. Think of it as renting money. The riskier your position, the higher the rent you’ll likely have to pay to compensate your lender for that risk.

Additionally, you’ll also pay broker and/or transaction fees or commissions. And, of course, the cows have to eat and be housed somewhere. Add all the costs together and you have what investors call “costs of carry.” That is, the cost of simply maintaining a position.

Leverage in Forex

In practice, the form of leverage most forex traders use is a loan from the brokerage house itself – a margin loan. These loans are almost always cheaper than credit cards or other forms of credit generally available to the trader, except maybe home equity loans. *

Now, compared to other forms of investing, U.S. rules allow you to load up pretty heavily with leverage: As high as 50:1 for major currencies, and 20:1 for minor currencies. That means if you’re trading dollars for euros or vice versa, and you put up a dollar of your own money, U.S. regulators will allow a U.S.-based broker to lend you up to 49 dollars for every dollar of your own money you put up. So for every $1,000 of your own money you put up, you can control up to $50,000 in assets. This is a sharp contrast to equity investing, in which you are only allowed to leverage 2:1 under current rules with a regular NYSE equities broker/dealer.

Even so, that’s significantly less than the 100:1 ratio that was all but an industry standard for Forex trading just a few years ago, and even 200:1 is not uncommon for non-U.S. based brokers. U.S. regulators restricted U.S.-based brokers to 50:1 in 2010, as the general environment in the United States was one of risk aversion.

When your trades make money

If you are leveraged, and your trades are making money, things are great. You can book the profits on a $50,000 deal, even though you only have put up 1/50th of that amount. You keep all the profits, and pay a little interest back to the broker to cover the money you borrowed, plus a transaction fee. Once you sell your position, you can either borrow a little more money – up to 49 times your new, somewhat increased account balance (because your last trade was profitable!), you can keep on trading without borrowing any additional money (at a somewhat reduced leverage ratio), or you can pay back some or all of your margin loan.

When your trades lose money

If your trading is losing money, the dark underbelly of leverage will become apparent very quickly. If you are maxed out at 50:1 when you start the position, and markets don’t break your way, your broker cannot allow your account to remain below its minimum margin requirement. You will quickly receive a demand to put up additional cash to bring your deposit back to the minimum level of a margin call – if you’re lucky.

Alternatively, your broker could simply sell off all your positions immediately, and salvage what it can. This is called a margin closeout. It will happen automatically as your equity – that is, the money you have invested in the account, after accounting for expenses and trading gains and losses, approaches zero.

It sounds harsh, but it’s really a safety mechanism. If the broker is fast enough on the draw, it can save you from having your account balance drop below zero – at which time you will not only have lost everything you invested, but you will actually owe the broker money.

*Note: I do not recommend using home equity loans to finance forex or any other day trading activity. Forex is risky, and it makes no sense to put one’s home at risk in order to finance forex trading. You are probably better off with less leverage than putting your home at risk.

Yes, some people will tell you that interest on home equity loans is tax deductible, up to the first $100,000 in principal. Well, they are right. But interest on debt incurred to invest in any taxable investment is deductible, anyway. There is no upside to using home equity loans secured by your family’s personal primary home or secondary home compared to other forms of inexpensive leverage.

You can deduct interest on debt secured by investment properties if you use the loan for investment or business purposes, but understand that you are putting the property at risk. Have a plan in case your forex trading doesn’t work out as intended.

Images courtesy of www.FreeDigitalPhotos.net

 

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Winners Edge Trading was founded in 2009 and is working to create the most current and useful Forex information and training available on the internet.

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