How Not To Lose Money With Online Foreign Exchange - Watch The Leverage
Online FX trading has exploded over the last several years. Look around the internet and there are so many brokers offering what on the surface looks like a great deal – plenty of leverage, zero commissions, free charts and good online trading platforms.
But as ever in this cynical world we must always take a peek behind the curtain to see what strings are in action.
Leverage - The Main Selling Point Of FX
Yes, leverage and plenty of it. In fact the brokers offer so much leverage perhaps their is a reason for it, ie give people too much rope and they’ll hang themselves!
What Exactly is Leverage?
- We'll use this quick example in the stockmarket
- If you buy £1,000 worth of shares your broker will expect you to have at least £1,000 deposited in your account to cover the full cost
- But if you use a broker that offers you leverage he might only ask for a 10% deposit and then loan you the £900 (the security is the value of the shares)
- When using leverage any move in the share price will be amplified per amount of capital employed
- It will therefore only take a 10% move in the stock price to either double your invested capital (£100) or lose it all….
The important point with using leverage is to never concentrate on its advantages rather always look at the risk involved because that’s where leverage will always do the most damage. When it comes to using leverage never focus on its upside potential, instead look 90% of the time at your downside because that's where leverage will always do the damage.
The FX Market Is Built On Leverage
In the FX world when somebody trades $100,000 of Dollar/Euro he or she never has to put up the $100,000. The broker instead will ask for a deposit which is sometimes referred to as Margin
Leverage is not the issue in the FX market but excessive leverage is. So the real problem with the online FX brokers is that they offer excessive margin of around 200:1. Some even now offer 400:1
At 200:1 a cash deposit of $5,000 can control a currency position of $1 million!
Critical Point - Who Takes The Other Side Of Your Trades?
In the stockmarket if you buy a share then somebody has to sell it, the futures and options market work on the same principle - an open market where all bids and offers are conducted through a central market place, the Exchange. But this is not the case with FX because there is no centralised Exchange, instead each broker quotes their own dealing prices.
When you therefore trade with an online FX broker you are trading against them, ie if you buy they will sell and vice versa.
This in itself is not a problem but it can be when excessive leverage is used because with excessive leverage it's almost impossible to stay in business for long.
It doesn't matter how good you are because one small slip can easily lose 25% to 50% of your account. And never forget the fact if you lose 50% of your capital it has to grow by 100% just to get back to even.
Massive Leverage + Client Speculation = Profits for the Broker
Generally speaking if a broker takes the opposing position to you (they always have the option to hedge) and offer their clients obscene amounts of leverage then it won't be long before the client's money is subtly transferred to the brokers account via the client losing money. And there's nothing wrong or illegal about this kind of business practice.
Think about it, what would you do if you were the broker?
If the majority of small FX clients lose money (because they use far too much leverage) why not just take the opposing side to all their trades. It’s just how the Casinos operate.
Sure, sometimes the clients will all get it right (say betting on a higher Dollar) and the broker will take a hit (some Casino customers occasionally win fortunes) but over the long term most of the clients money will become yours.
How Much Leverage To Use
There are some excellent trading opportunities in the FX markets, especially as they tend to trend well over the weeks and months. But instead of falling for the marketing blitz of excessive leverage get smart and use it in far more practicable terms.
Anything more than 20 times leverage is enough for most traders in most situations which is also the amount of leverage that futures offer. Believe us when we tell you that with 20 x leverage fortunes can be made and the savvy customer who recognises this has a far better chance of staying in business over the coming years.
Ultimately, if you use the 200:1 or even 400:1 leverage on offer in the FX world you’ll find yourself working for the broker rather than the other way around.
Good luck with your FX trading!
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