Forex and the Dangers of Leverage

By: Justin Stewart

It's a known fact that the individual investor or trader achieves greater leverage in the Forex market versus other trading venues. An example has been made of choosing between investing in shares of a stock or in the Forex futures to illustrate how leverage works. You could invest $1,000 in only 10 shares of a particular stock, or you could take that same $1,000 and invest it in five different futures contracts of 100 shares each, therefore enabling you to be controlling 500 shares overall compared to only with stocks. This example is a moot point about which one to invest in, so why ask?

Excessive leverage can only result in two outcomes for the investor --- excessive gain or excessive loss. Excessive leverage can enlarge your losses in as a great a magnitude as the way in which it can enlarge those profits, so the investor needs to be very careful in any endeavors where leverage gets too high. Just remember, the greater the leverage that you apply with a capital investment, the greater the risk you take of losing it.

Risk is not always associated with leverage that is margin-based, but it will influence it if the investor does not take some precautions. Here's an example using the following chart to illustrate a key point.

Trader A Trader B
Trading Capital $10,000 $10,000
Real Leverage Used 50 times 5 times
Total Value of Transaction $500,000 $50,000
In the Case of a 100-Pip Loss -$4,150 -$415
% Loss of Trading Capital 41.5% 4.15%
% of Trading Capital Remaining 58.5% 95.8%

Figure 1: All figures in U.S. dollars

Both Trader A and B have $10,000 and execute a broker trade requiring a that they deposit 1%. After looking at the USD/JPY they both figure that it will top at around 120 and then start to decrease in value, so they short it at a price of 120. Trader A then applies a leverage factor of 50:1 (equating to $500,000 on his $10,000 investment), Because the USD/JPY settles at 120, one pip (point) for a standard lot equals approximately $8.30 USD, so the pip for five of these lots would be $41.50 USD. To further the point, let's say that the USD/JPY hits 121. Trader A has just lost 100 pips on the trade which means that he is out $4,150 USD.

On the other hand, Trader B opts to be more cautious and applies only a 5:1 leverage factor to his trade. Even though the USD/JPY hits 121, and Trader B loses 100 pips just like Trader A did, he has only lost $415 or 10% of what Trader A encountered in the loss. Does that illustrate the point about being careful with applying leverage?

The bottom line is that excessive leverage can kill your gains very quickly. So if you apply a smaller leverage factor, you will be able to give your trades more breathing room, so to speak, by employing a wider stop range. This in turn will result in avoiding in the risk of using (and losing) too much of your capital investment.

Foreign Exchange
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