Leveraged trading is a risky venture. Many forex traders got involved with forex trading without understanding what it means to deal in leveraged trading and consequently ended in failure.
Two things that often being quoted as the advantage of forex trading are the availability of leverage and flexible margin. Indeed, leveraged trading has changed the world since its inception, and continue on to this day. Leveraged trading opens up the possibility for ordinary people, the likes that have no rich relatives leave behind huge inheritance nor have good enough talent to work in big companies, to take advantage of the billions of dollars that floats in the financial market. However, leveraged trading also is a risky venture. Many forex traders got involved with forex trading without understanding what it means to deal in leveraged trading and consequently ended in failure.
Psychological Effect Of High Leverage
Leveraged trading refers to the ability to trade in financial market with borrowed money based on a certain collateral numbered at proportional measure with the borrowed amount. For example, with 1:1000 leverage, someone could trade with the power of 100,000 USD by just providing 100 USD as margin. Where do the 999,900 USD borrowed from? it is from his broker. Not only in forex trading, ordinary stockbroker oftentimes also providing leverage for their clients on far smaller proportion, or around 1:2 or 1:3. Convenient, isn't it!?
However, many warned against making full use of leverage advantages. Leverage disguise the real amount of funds in our account and any changes on it, as well as influencing us psychologically. Big profits could turn out smaller, and small losses could turn out bigger. Therefore, the higher the leverage, the higher the risk. Not to mention the liquidity risks it brings for the entities that facilitate the trade themselves. In fact, financial market authorities often took the time to put a cap on how much leverage forex brokers may provide. The US and Japan regulator have limited leverage offered by licensed forex brokers at 1:50, a step that only recently emulated by Russia.
Still, licensed forex brokers outside of those regions as well as unlicensed brokers might place a high leverage as high as their liquidity allows, sometimes up to 1:1000. In this case, traders must be able to restrain themselves and calculate objectively how much leverage he can handle so as not to distort his judgments.
Uncertain Margin Requirement
Margin requirement refers to how much money needed to provide collateral in proportion to the amount of money one wants to control in a leveraged trading. A margin requirement of 5% implies maximum leverage of 1:20, while margin requirement of 0.5% implies available leverage up to 1:200, and so on.
Traders usually can choose their own margin below the limit conditioned by their broker, but there are also instances when brokers shift required margin lower or higher when market condition changes. It needs to be understood that margin requirement also depends on the available liquidity, so when liquidity reduced, margin requirement increased. The latest of such event is when Ruble tumbled in December 2014, an event which has made several brokers turned off trading on RUB pairs and lifted margin requirement to trade the pair in accordance with ongoing market discord.
Apart from such incidentals, there are also forex brokers that outrightly stated they use floating leverage in which leverage could vary at different times of the day. As such, forex traders need to be aware that margin reqirement changes might happen any time and influence their positions regardless of the availability of fund in their balance.
Confusing Margin Call
One thing that newbies often confused about is how much forex trading differs with the act of buying and selling foreign currencies through money changers or banks. When one buys foreign currencies from bank at a certain price in order to sell it at later date with higher price, he can keep the money till as long as he wishes regardless of how the currencies' exchange rate changes over time. But when someone trades forex in leveraged trading scheme, a certain position could instantly be halted at market price by his broker when the amount of money in his balance cannot cover probable losses as prices move far below or beyond his expectation. This is what is called Margin Call.
Margin Call could be your friend or foe, depends on how much you understand about it. It is responsible for the losses suffered by many beginner traders, but it has also helped many traders to pass through unexpected market condition changes without having their account wiped out. Generally, forex brokers seem to place margin call at 20%; which means open positions will be closed the instant you used 80% of your balance. In order for it to be an advantage instead of risk, traders need to understand the concept of Margin Requirement as outlined in the last section, Account Margin which basically is the funds you have as your account balance, also Used Margin and Available Margin.
Used Margin refers to the money the broker locked when someone open a certain position. You will not be able to use it, as it will be released only after you close the position. While Available Margin points to the funds left after you open a position and the broker deduced Used Margin from your balance. Available margin may go up and down depends on the fluctuation of market prices. And the funds left as available margin are what counts as balance that may or may not get you into margin call.
As mentioned, general idea seems to place margin call at 20%. However, there are forex brokers that place higher limit or none at all and let you determine it on your own. In the end, forex trading is about how to manage one's own funds and gain optimum advantage from it. In order to do that, traders should always ensure that their understanding on these concepts are on par or even better than most.