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April 23, 2016

Leverage in details: How it works, Pros and Cons.

Leverage in details: How it works, Pros and Cons.

So you heard some stories that having $200 of your own capital you can turn it $500 or $1000 in a couple of trades. How come that it is possible? No you don’t need to visit casino, just use such wonderful thing as a financial leverage. It is a short-term loan given to a trader, proportional to his deposit. The purpose of this loan is to multiply gains, but as nothing good comes without bad you also multiply losses using it. Basically it allows a trader to earn MORE or to earn FASTER. Or lose in the same manner.
In newbie trader hands high leverage often leads to wiping out trading capital. The problem lies in psychology: it is natural that a human prefers to increase odds of happening of something desirable and decrease probability of happening of something unwelcome, even if both events have equal odds to happen. In trading it results in overrating EXPECTED returns and underrating REAL risks.I want all newbies to read it twice and understand, because it forms a basis of trading using high leverage.
So to get a better understanding of the leverage let’s compare how trading goes with and without it (hope you read my previous article how forex works and know how profit forms in currency speculations)

Trading without leverage (or 1:1 leverage)

Suppose you have $200 and read news today that US Federal Reserve is going to decrease interest rate from 1.00% to 0.50%. Basically it means that the Bank wants to make borrowings of US Dollar cheaper (better to pay 0.5% interest than 1%, isn’t it?). It is reasonable to expect US Dollar will drop against other currencies. You simply exchange your $200 to Euro by the current exchange rate of 1.1300 and get 177 EUR. Federal Reserve does decrease the rate to 0.5%, US Dollar depreciates against other currencies and EUR/USD exchange rate surges to 1.1500. You exchange your 177 EUR back to US Dollars and get 177*1.15=203.55 bucks. Congratulations – you beat the market and earned 3.55 Dollars from forex trading!

Trading with 1:500 leverage

Having $200 and applying all 1:500 leverage you virtually get 200*500=100 000$.  It’s sad, but you can’t withdraw them, I tried :). Basically those money are available for you only when you open some position and they’re automatically deducted when you close a trade. So you open same position in the example above ( buy EUR for Dollars) but now use your leverage. Exchanging 100 000$ to EUR you receive 100 000/1.13 = 88.495 EUR. When you exchange it back when exchange rate rose to 1.15 you receive 88.495*1.15=101769 Dollars. You return the loan and your profit is 1769-200=1569 bucks.

Looks pretty good but don’t hurry to follow this perfect scenario. Lets consider the underside of the leverage – when you are wrong with a market forecast and leverage starts to work against you:

For example the Federal Reserve decided to leave the interest rate untouched at 1.00% and Dollar appreciated against other currencies. EUR/USD exchange rate dropped to 1.1000 on the news. In case of 1:1 leverage if you decide to make reverse exchange you get back 177*1.10=194.7 bucks or bear $5.3 loss.

But what happens with a leveraged trade?

As you exchanged $100 000 to 88 495 EUR at 1.1300 and exchange rate dropped to 1.1000 you get back 88 495*1.10 = $97 345. But you have only $200 in your account what about rest of the loss? Does broker pay it for you? The answer is NO. The broker won’t simply allow you to hold position open till the rate drops to 1.1000 and close your position even earlier. Earlier, but where? To calculate that you need to understand what is pip value and how much profit or loss you get when exchange rate moves by 1 pip.

1 pip is 0.0001 of exchange rate or 1/10000th of the trade size. In our case, 1 pip move causes a change from 1.1300 to 1.1301 (pip up) or 1.1299 (pip down)
In case of 1:1 leverage and $200 position, 1 pip value (in $) is (0.0001*200)/1.13=0.018 or 1.8 euro cents. That’s why when exchange rate dropped from 1.1300 to 1.1000 (300 pips) you could lose 0.018*300 pips~ $5.3.
But when you trade full standard lot ($100 000) pip value is (0.0001*100 000)/1.13= 8.85 EUR. So basically it means that your own deposit of $200 will be wiped out for 22.59 pips. It means that your balance will be zero at only 1.1278 rate. As you can see when using leverage the speed of earning and losing increases significantly.

A careful reader may ask: is it safe for brokers to provide such a big loans (leverage) for traders? The answer is YES, its almost 100% safe for a broker to offer leverage to traders. As currency market has a very high liquidity, when your position reaches critical drawdown, brokers automatically make reversal exchange deduct the loan and leave you with losses. To protect themselves from risks connected with leverage, a position is closed when drawdown reaches 30% of required margin. In our example above, in case of drawdown your position will be automatically closed when drawdown reaches 70% from $200 or 140 bucks. There’ll be only 60 left in your account.

So here is the real trading example of how you can safely and effectively use leverage with SMALL deposit:

Screen Shot 2016-04-22 at 9.34.29 PM

If you have any suggestions or question feel free to ask them in comments
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