These are two of the most misused and misunderstood terms in trading, and yet there are thousands of forex traders happily trading, who have little or no grasp of these basic terms, or what they actually mean. And the first point to clarify is that leverage and margin are very different, and as such represent very different things.
They are not the same, nor are they interchangeable terms. So what is leverage, and what is margin, and why is it so important to understand the basic concepts of these two key financial terms?
Let me start with a simple example.
Suppose you have gone to the casino with some friends, and you have a hundred dollars in your pocket for the evening. You begin to bet on the roulette wheel.
Unfortunately you are out of luck, and after a few minutes you have lost all of your money. At this point you ask one of your friends to lend you another one hundred dollars, so that you can carry on playing. Sadly your run of bad luck continues, and you lose this as well. At that point you decide to quit and leave the table.
What have you lost, and how much do you owe?
Well in simple terms, you have lost your own one hundred dollars, the borrowed one hundred dollars, and you also owe your friend one hundred dollars. In other words, 200% of your original starting capital.
In effect what you were doing when gambling with the second one hundred dollars, was betting using borrowed money, and in essence this is what leverage is all about. It is a loan given to you by your broker in order to allow you to magnify your trading profits.
However, what many traders neglect to appreciate is that this will also magnify your trading losses as well. Now leverage is used in all walks of life, and indeed
you can think of a mortgage to buy your house as leverage. If you look for a definition of leverage, you may come across the following which really explains what it is:
“leverage is the use of credit or borrowed funds, to improve one’s speculative capacity and increase the rate of return from an investment, as in buying securities on margin”
Now if we take the first part of this statement and then look at margin in a minute, we can think of leverage in many different ways. One of my favourite analogies is to use property. A property speculator uses mortgages to increase leverage, to buy more properties to add to his or her portfolio.
Without the lender, all they would be able to afford would be the outright cash purchase of the asset with their own money, so we use lenders to ‘leverage returns’ on our houses, whether for personal use, or as a landlord. This is all well and good when property prices are rising fast, and one of the favourite strategies of property speculators was to constantly refinance as the capital values increased, releasing equity from the portfolio to buy more properties. The banks and finance companies were happy to oblige, until global economies collapsed with the consequent meltdown in property values, and subsequent repossessions!
Now before moving on, let me just finish our property example, which will then put the whole issue into context for you. It will also help you to understand what leverage is, and how dangerous it can be. It has a huge benefit of course, but is a double edged sword which is why I have taken some time with this example to make the point.
Suppose we take a typical property here in the UK, and imagine we are buying a small house for our portfolio. Most lenders require a deposit (on average), somewhere in the region of 20%, in return for providing the balance of 80%. What this means, in effect is that the bank is offering leverage of one hundred divided by twenty (100/20) or 5 to 1.
In this case, and in order to keep the numbers simple, if we have £20,000 as a deposit we could then afford to buy a house at £100,000. The formula for leverage is very straightforward and is simply the property value divided by the deposit amount. In this case it’s one hundred, divided by twenty, which is five. Now let’s equate this to the forex market, and the first thing you will see when looking at all the hundreds of forex brokers, is that they all offer different
leverage levels on their accounts. These are expressed as a ratio, just as in our simple example above. The minimum leverage offered by most forex brokers is fifty to one, followed by one hundred to one and even as high as four hundred to one!
If we just think about this for a minute in the context of our property example above, and use four hundred to one. This means that a mortgage lender could offer us a loan of £8,000,000 (eight million pounds sterling !!) against a £20,000 deposit.
Can you imagine any lender in their right mind offering this sort of leverage - unthinkable. And yet until recently this was what was being offered by many forex brokers to their novice clients. In the context of property you wouldn’t even consider such an offer as you would only survive for one month, before the first mortgage payment was due, followed by a swift repossession and bankruptcy. Fortunately, in the last few years the various regulatory authorities have started to curb the worst excesses of some brokers in the forex market, led by the CFTC in the US.
This has forced many of them offshore as a result, and thankfully the days of bucket shop operators with absurd leverages are coming to an end. I will cover this in more detail once we start looking at the various types of forex brokers and the questions that you need to ask before opening an account. It took the CFTC and NFA years to act, but they have tightened the regulations for US brokers considerably since the early days, with leverage now capped at 50:1. However, as I mentioned earlier, this has simply forced many brokers offshore, into overseas jurisdictions, and avoiding these regulations as a result. Further legislation is now in the pipeline to cut leverage to a maximum of 10:1, and to force brokers to register by law with the appropriate authorities.
I hope that the above simple example has not only explained what leverage is, but also how dangerous it can be when you fail to understand the underlying concepts and risks. We are going to take a look at some examples in the forex market in a moment, and of course why we have leverage in the first place, but hopefully you now have a clear understanding of what leverage is.
The other side of the equation is margin. In a way we have already covered this, as margin is in effect your deposit or the amount of money that you have to place with your lender or broker. It is your sign of good faith that you have sufficient funds. It is the entry ticket to the market, and once your margin or deposit is safely with your lender or broker, then they will release the funds, or
advance the loan, as their sign of good faith. In broker terms this is generally referred to universally as ‘initial margin’, which is your deposit.
To summarise. Leverage is the loan element of the contract, and is the money advanced by the broker or lender, whilst margin is the money you put into the asset or account and represents the cost of entry. However this is not the end of the story as you will see.
The next question is why do we have to have leverage in the first place, and this is partly answered by our property example which we looked at earlier. Without it, property prices would be substantially lower, as no-one would be able to afford more than they could afford in cash. Secondly, the lenders would not make any money, as they would have no loans on which to charge interest. In order to put this all into context in terms of trading forex, let’s look at a simple example using no leverage, and then the same example using leverage of 100/1, and see what happens as a result.
If we take the USD/JPY as an example, and at today’s exchange rate the pair are trading at 102.50, which means that for every one US dollar we would be able to buy 102.50 Japanese yen.
Now suppose we have placed $1,000 of margin (our deposit) in our account which has a leverage of 100:1.
For our first trade we are going to use no leverage. Effectively we are trading at a ratio of 1:1 with no borrowed funds. In other words we are just using our own cash.
In our forex trading account we have our $1,000, so we can buy a thousand times 102.50, or 102,500 Japanese yen. Here we are selling the US dollar and buying the Japanese yen. A short position in other words. Suppose the currency pair moves to an exchange rate of 102.00, how many US dollars can we now get for our yen ?
In order to arrive at the answer we simply divide 102,500 (the amount we started with in yen) by the new exchange rate which is now 102, which gives us $1,004.90. In other words our initial $1,000 has now become $1,004.90, and we have made a profit, (if we closed the position at this exchange rate) of $1,004.90 - $1,000.00, or $4.90.
Not terribly exciting, when we consider that this currency pair might move this amount in one day’s trading, and probably more, and therefore unlikely to yield
any substantial profits for anyone using a 1:1 leverage. Now if we had $10,000 in our account, this would make things a little more interesting, and we would have made $49.00 (10 times). Equally with $100,000 in our account, this would then be $490 (100 times), which starts to become more interesting.
And this in essence, is where the broker steps in with leverage, since not many of us have $100,000 sitting around doing nothing, but if we did, we could happily trade this way with our own money, effectively leveraging ourselves if you like.
Now let’s take another example, but this time using our leverage of 100:1 with the forex broker, and in this case (and I have already given the game away above), the outcome is more interesting!
With our leverage from our margin of $1,000, we can now buy 100,000 x 102.50 yen or 10,250,000.00 yen . Consequently, when we close the trade at the new exchange rate of 102.00, this then becomes 102,500,000.00/102 = $100,490.20 leaving a profit of $100,490.20 - $100,000 = $490.20.
This is the power of leverage. The corollary is that this could equally have been a loss of $490.20 for a relatively small move in the market. Now the other attraction of leverage is in the returns it generates, in percentage terms. After all, we have just generated $490 using only $1,000 of our own money, a staggering return on investment of 49% per cent over the miserly 0.49% using our own money and with no leverage. Once again, demonstrating the power of leverage.
The question you might reasonably ask at this stage is what is an acceptable level of leverage for your account. Here I can only give you my advice, which is backed up by the views of professional traders, who limit their leverages to somewhere between 5:1 and 10:1. And in some ways this is confirmed by the new rules now in prospect for US forex brokers, with the regulatory authorities now looking to cap leverage at a maximum of 10:1. This often comes as a complete surprise to many forex retail traders, and only goes to show how dangerous leverage can be if you don’t understand how it works, and the advantages and disadvantages of using it. Just remember the example with our house - would you really consider buying an £8m house, with just £20,000. My own view, for what it’s worth, is that as a novice trader the maximum leverage you should consider is 50:1 and certainly no more, and less if possible. The CFTC in America has increasingly tightened the legislation for
brokers in this area. Over the next few years we are likely to see leverages falling dramatically, as the bucket shop brokers are cleared out and a more orderly and professional market is created.
Just to put this into context for you, the leverage offered on equities is never more than two to one, so just remember this when you are looking at the various broker offerings. We’ll come back to this issue once we start to look at the broker types in more detail, later in the book.
Now that we understand a little about leverage and margin, in the remainder of the chapter I’m going to explain some of the other financial terms you’re going to come across in your trading account, as well as explain how currency pairs are quoted and settled, how profits and losses are calculated, and also explain about rollovers and interest rates.
And before we start on the next section, a word about broker terminology and the terms of the account. Whilst some brokers use the same terms to explain aspects of the account, others will differ. There is no standard terminology, so the terms used may differ from account to account. The only one that is generally common is initial margin which we looked at earlier.
Second, the terms of each broker account will be different and this I’m afraid means that you have to read the small print or contact them by phone or live chat and ask. Don’t be afraid to ask and get them to explain until you are absolutely clear as to how they operate, in terms of their rules and procedures. My job here is to give you as much broad information as I can so that at least you understand the principles, and therefore also know the questions to ask and to phrase them in broker terminology.