What is Leverage in Forex Trading? Understand the Risks
Forex Basics

What is Leverage in Forex Trading? Understand the Risks

As you trader you would definitely have heard about leverage, and very likely used it in your trades.

Leverage in forex & CFD trading simply means borrowing money from your CFD broker to place a trade with larger position size. You invest a certain amount with your broker and your broker may allow certain leverage limits to you.

Leverage allows to magnify potential profits, which is the main reason why inexperienced traders are drawn to use high leverages without considering the risks.

Leverage is considered as a ‘double edged sword’. This is mainly due to the losses incurred by traders by using high leverage limits. Around 70% of traders lose their money while trading CFDs, and it is accepted by multiple regulators that high leverage is the main reason for this risk.

What is Leverage in Forex?

Forex & other instruments like commodities, indices at CFD brokers are mostly traded as a CFDs. This means that you don’t own any underlying instrument, but are essentially betting on the rise or fall of the price of that instrument.

For example, if you think that EUR will rise against USD, then you can place a buy order on EURUSD, and profit from the difference.

But most traders have lesser capital to make any substantial gains. That is where CFD brokers offer leverage.

By borrowing from your broker, you will be able to take bigger positions in the market by just investing between 0.25%-5% of the entire trade volume.

For example, hypothetically your broker gives you a leverage of 1:30. You decide to invest $500 at the leverage limit given to you. Which means you can take a position up to $15,000. This means that you put in $500 and you borrow $14,500. Here you can see that you are investing just $500 but your leverage allows you to trade up to $15,000.  

In case the markets are not favourable to you, and you lose money in the trade, you could end up being liable to pay up a lot more than what you put as your margin. Although, through features such as stop-loss, you can decide to automatically cut your position if the loss is going behind what you can cover.

There are other terms that you might come across while trading CFDs using leverage.  

What is Margin?

Margin is the amount required by your broker for you to deposit/have in your trading account to open a position. It is connected to the leverage that you want to use.

The margin is usually a percentage of the position you are willing to take. The percentage however differs from broker to broker but it varies between 0.25%-5%.

Assuming you want to take a position of $15,000 dollars in the market, at a leverage of 1:100, the margin required will be 1%.

What is Margin Call?

This is a warning given to the trader to either put up more margin money or the broker will automatically close the trading position.

This happens when the trader’s position in the market has reached a point where he/she no longer has enough money in trading account required to cover the losses.

In order for you to hold your position, the broker will ask you to deposit more money. If you are unable to deposit within a specific amount of time then your open positions be automatically closed.

Given the risks of leverage, currently there are several restrictions which have been introduced by FCA, ESMA, ASIC and some other regulators around the world to reduce leverage limits allowed for retail-traders due to its high-risk nature.

The Risks of Leverage

The Forex market is highly volatile, this requires you to constantly monitor your positions. The problem with leverage is that within a matter of seconds, you can either gain profit or see a big loss, compared to your invested capital.

How many points you gain or drop is entirely up to the market volatility but there’s high chances that it might go either way. So, if you are trading with leverage then it’s important that you watch your positions very closely, and use risk management tools.

Here’s an example, John has $1,000 that he wishes to use as capital for CFD trading. The broker he chooses has a 1% margin as deposit policy. John does his research and concludes that US Dollar would drop due to lower demand compared to EUR. So, let’s say he decides to long EUR/USD at 1.2000.

Based on the $1,000 trading capital, John chooses to use 1:100 leverage on this trade by longing US$100,000 worth of position i.e., 1 Standard lots.

Let’s assume that EUR/USD drops by 100 pips to $1.1900 in 1 hour. John will lose approx. $1000 on this trade. Just a decrease in 1 pip can lead to loss of $10 for him.

Trading Capital $1,000
Leverage Used 1:100
Total Trading Volume $100,000
100 pips loss $1000
Loss in % of capital 100%
% of total capital remaining 0%

In this example, with 1:100, John would lose his entire trading capital on a single trade. Some brokers offer very higher leverage of as high as 1:2000 or more, which is even riskier.

Restrictions on Leverage

Some brokers still offer as high as up to 1:2000 with Standard & Micro account. Considering how many people were losing money due to high leverage limits, the regulators in major countries like UK, EU, Australia, decided to step in to mitigate this damage.

In its investigation report, ASIC in their report published in 2020 during COVID-19 volatility, investors who traded in CFD’s lost $234 million AUD in a single week at 12 CFD providers. This figure increased to $774 million AUD in 5-week period in March-April. During which over 1.1 million CFD positions were closed under margin calls. And more than 15,000 retail client accounts went into negative balance of $10.9 million AUD.

ASIC had proposed the restrictions on CFDs in 2019 which mirrored regulations the CFD restrictions by ESMA. Following the public consultations from all stakeholders in 2019, ASIC delayed the rollout of these restrictions. In October 2020, ASIC announced that it would finally implement the limits on leverage for CFD’s instruments offered by regulated brokers to retail traders citing reviews conducted in 2017, 2019 and 2020 in which they found retail clients losing a lot of money from CFDs, this restriction was announced in Product intervention order which will come into effect from 29 March 2021. The maximum leverage which was decided was 1:30 for major forex pairs. The leverage is even lower for other CFD instruments, given their risks.    

On the other hand, FCA reported that prior to the introduction of the CFD restrictions on 1st August 2019, trader’s losses accounted to £1.07 billion per year. The FCA projects that the restrictions in leverage will help reduce losses between £267 million and £451 million every year.

Though the restrictions by ESMA and other European regulators helped curtail losses, there was nearly 30% drop in the number of trades that was being done at European Brokers in 2019, like Oanda reported 20% decline in European revenue due to this. As number of traders shifted to brokers abroad that offered higher leverage like those in Australia & offshore destinations like Seychelles or Mauritius. But since, ASIC has now also implemented the regulations many Australian brokers are welcoming this move and are keen on making necessary changes to remain complaint. Many experts believe that this will bring awareness among traders about the risks in the long run, and brokers will be encouraged to offer safe offerings. The retail trading industry will be more organised and gain credibility as more professional traders will enter the market and market will balance itself out.

But, still there are many brokers that offer much higher leverage. Especially, the brokers that are registered with Offshore regulators and developing nations that don’t follow these restrictions on leverage to traders.

As per Forex Brokers South Africa, there are many Tier-2 & Tier-3 regulators that have lower restrictions compared to ESMA, FCA, ASIC etc. For example, in Africa, FSCA is the largest regulator on the continent & many South African forex brokers regulated by FSCA offer as high as 1:400 leverage. Similarly, CMA regulated forex brokers in Kenya also offer similar leverage levels.

Also, in Asia, many European CFD brokers are very popular & they offer very high leverage without much restrictions as they are not regulated locally, often registering traders under Offshore regulations in countries like Belize, Mauritius etc.

The African & Asian continents have witnessed a consistent rise in number of Forex traders over the years. There is need for more restrictions on leverage & marketing by brokers in these regions.

With more and more countries bringing in regulations to protect traders, we can expect to see changes in the upcoming years.

But the problem with leverage restrictions is that if experienced traders want a higher leverage, they can still get it with offshore brokers.

Why you should avoid high Leverage brokers

There’s one thing you should keep in mind, regardless of whether you make money or not, your broker will make money.

Apart from the normal spread, there’s always the margin interest fee that the broker will charge. There are also the other charges such as transaction fee, withdrawal fees and so on. As your trading volume increases, the fees and the commission charges also increase.  

So, your breakeven point keeps getting higher and higher even with higher leverage levels. You will need to reach a particular target price to ensure that you make a profit. So, there will be constant pressure on you to break even in order for you to pay your broker. This will indirectly affect the way you trade.

And by using high leverage & risking more, it makes it even more likely that you will lose money. So, it should be in your best interest to consider safe or no leverage.

When a broker offers you higher leverage levels, they are trying to induce you and make bigger profits from your trade. This is why regulations exist to protect traders from such unethical brokers.

When a broker offers more than 1:30 leverage level then it’s almost certain that there are not regulated or don’t possess all the necessary licenses to be a CFD broker.  

In fact, next time you across a broker who offers you ratios such as 1:1000 or higher than that, have a look at their address and where they are located. Check if the country they are located in have a regulator at all and check if they are authorised to be a broker in your country.

All regulators around the globe are working together to curb the losses generated within the CFD trading industry. This is the reason why you see so many regulations & their restrictions being similar to one another. Another reason why regulators work together is because of offshore brokers.

Offshore brokers don’t have any license and do fall under any major regulations. They can easily cheat traders without having to worry about being penalised.

The strategy that many offshore brokers adopt is that they never carry out the orders to liquidity providers, and instead take the opposite side of a trade, Given the knowledge that most traders lose, they just wait for the trader to deplete their account. This way they will get the complete deposit of the trader as their profit.

Well-known brokers will need to ensure that withdrawals happen quickly but the same is not the case with offshore brokers. Most of the times you will not be able to withdraw your funds and you are forced to use your funds to trade.

It’s almost impossible that you will find any retail trader who has genuinely made money with CFD brokers who are not regulated or licensed. This is why it’s important to choose broker who are regulated by ASIC, FCA, ESMA or any other regulator from your country.