Part 2 in a series: Why Professional Traders Trade Forex. Reason 2: Leverage
Leverage is a double-edged sword. Some love it and some hate it. For some it's risky, for others, when managed correctly, it's an essential tool. I am sure we can all agree that high leverage is particularly risky in the wrong hands yet it does have some benefits and for those that understand the markets, the risks and how to manage the risks, it can be a useful investment tool.
What is leverage?
Leverage is the ability to own or control a larger asset or security for a smaller down payment. Buying a house with a mortgage is a perfect example of leverage at work. You go to the bank with say $100k ready to use as a deposit and say "I want to buy a house for $500k". Provided the bank agrees, then they have just offered you leverage - the ability to control an asset worth $500k for the smaller down payment of $100k.
Sticking to the home ownership theme, let's assess the risk of using leverage, to buy property. The biggest risk is usually at the point of sale. In a perfect world the sale price of the property is at least the same or more than the purchase price. This means the owner gets their money back, repays the bank and might even be left with a profit.
But what if the property is worth less?
Let's look at two scenarios for a property bought for $500k with a $400k loan and $100k deposit:
1. The property sells for $450k, a $50k loss. The homeowner still has to repay $400k to the bank and therefore the $50k loss is theirs to bear.
2. The property sells for $350k, a $150k loss. The homeowner has not only lost their $100k deposit but they have also lost $50k of the bank's money which they now owe the bank.
Scenario 2 is unfortunate and this exact scenario makes leverage risky when there is the possibility of losing more than your initial deposit. The banks assess the level of risk upfront and decide how much they are willing to lend based on that calculated risk. In good times they tend to lend the most e.g. 5 per cent deposits are common but in bad times when risk is considered the greatest, the banks tend to require larger deposits as they are trying to avoid the scenario of the customer owing them money.
Leverage in the forex market
Leverage for forex trading is the highest of any market. Many forex brokers operating in New Zealand provide leverage of 200:1 and even 400:1. Compare this to a 5 per cent deposit on a house which is 20:1 leverage (20 times your deposit) and you can see that forex has a whole lot of leverage available!
Some people see this leverage as risky and others see it as a benefit. The reality is that it can be both and it is somewhat of a double-edged sword as per the opening statement. The risky argument is that anytime that someone can put $1000 into an account and trade a $200k forex position (that's what you can do with 200:1 leverage) that the risk is very high. Indeed it is! The counter argument is that just because you 'can' put $1000 into an account and trade a $200k position does not mean that you 'should' put $1000 into an account and trade a $200k position! Anyone that does such a thing is either trying to get rich quick and is therefore gambling or 'taking a punt' or they have not got a clue what they are doing - most likely all of the above.
People who try to get rich quickly from the markets have unrealistic expectations and certainly do not have a professional trader's mentality. This approach is dangerous and the market helps a lot more people get poor quickly than the alternative. A lot of people do exactly this however - they lose all their money very quickly due to their own mistakes and then go and tell people how risky forex trading is. Risky, yes. VERY risky in the wrong hands, without a shadow of a doubt!
The benefit argument by those that enjoy forex trading and the leverage it provides plus understand the risks and manage them well and make sure they have the required knowledge and education before commencing trading is this; they can put a smaller amount of money into their trading account, therefore have a smaller amount of capital exposed to the market and still trade their standard position sizes. A trader with $200k of real capital to trade with does not need to put that full $200k into their trading account. Leverage allows them to expose a much smaller amount of their capital, let's say $20k, and the other $180k can be left elsewhere with less risk e.g. in a bank account earning interest. This forms part of a risk management plan in itself by keeping the trader's money diversified.
The professional trader also uses a stop loss as a risk aversion tool. A stop loss is a predefined point where they will automatically take their loss if the trade goes against them. Professionals use stops religiously, know when they are wrong and cut their losses quickly. Amateurs hold on to losing trades and let them become bigger losses in the 'hope' that they will come back to profit. This is risky for the amateur but the biggest risk is in the hands of the inexperienced trader themselves.
Whenever you open a forex account you will see a message something along the lines of 'Forex trading involves risk and it is possible that losses will exceed your margin deposit'. Your margin deposit is like the money put down as a deposit on a house that we described above. In the house buying scenario, we also know that losses can exceed if the property deposit if price moves against us. Traders have to put some real money down and the forex broker will provide them with leverage to trade a larger position.
This leverage can be used for good, it can also be abused and can assist traders to lose a lot of money fast if used the wrong way. Please spend some time to learn first, learn to manage risk and use stop losses, even if you learn nothing else. Have realistic expectations and DO NOT try to get rich quick from the forex markets. Keep risk low, focus on learning and give yourself a chance to become a good trader.
First and foremost to succeed as a trader we must preserve our capital, only then do we give ourselves a chance of success. To sign off with another quote, this time from Alexander Elder: "A good trader watches his or her capital as successfully as a professional scuba-diver watches his or her air supply".
Next week we will continue to look at reasons why professional traders trade forex.