A question was posted on BabyPips which occurred to me as being something readers here might wonder about as well.
I understand that it comes from other people’s deposits and from the broker’s capital. However, where is the limit? I understand that with stocks, its basically a loan from a bank, i.e., you will pay interest if you hold it for any appreciable amount of time.
Forex has only the interest rates on the currency themselves. But, there has to be limit, right? To do a crazy example, let’s say you dumped $10mil cash in a forex account. At 1:400, that would be $4 billion. That makes no sense since most brokers don’t have nearly that amount of capital – even if they did, it would leave no capital left for other traders to use.
So where exactly does the money come from? Most offer high leverage in comparison to stocks, or certain other instruments, so I’m just wondering how this is possible. I’m aware that not everyone will be using 100% leverage 100% of the time, but there still has to be limits.
The question comes from what would seem to be an incorrect mental point of reference where the forex market is concerned. The poster is expressing things in terms of stocks where actual ownership of an asset takes place. This is erroneous. Spot forex is akin to the futures market where traders are exchanging agreements, not ownership.
Forex = Futures
In the futures market when a trader goes long gold, for example, what’s happening is that they are agreeing to buy gold at a defined price at some specified time in the future. They aren’t buying the gold now, just agreeing to so it in the future – thus the term “futures”. The value of their position is based on the fact that their agreement is at a fixed price, while market prices are changing, potentially giving them a chance to sell that gold (were they to take delivery) at a higher price than where they bought it. Of course they do not have to hold the futures position through until delivery. They can simply enter into an offsetting agreement and thereby get flat.
Spot forex is basically a 2-day futures contract (technically a forward, but they are essentially the same thing). That means when a trader goes long EUR/USD, for example, they have entered into an agreement to provide USD in exchange for receiving EUR. When the trader wants to close out that position they enter into an offsetting agreement (call it going short if you like). If the trader holds a position overnight, the broker basically offsets the open trade at the end of the current day and then opens a new one at the start of the new day. That’s the roll. Depending on the broker that is either obvious or transparent.
Margin is Surety, Not Down Payment
With forex being an agreement based market, not an ownership market, the capital requirements of the liquidity providers are much lower relative to the size of the trading volumes than would otherwise be the case. This is because margin in forex (and futures) is a surety for the broker (and the system as a whole) to make sure there is coverage for any variation in the value of the future/forward contract the trader might experience. This is different from in stocks where a trader operating on margin is actually borrowing money to be able to purchase (thus own) more stock than they could have otherwise, much like a home-buyer takes out a mortgage. The stock margin is basically a collateralized loan.
No Ownership Means Lower Capital Requirements
Since a forex broker isn”t actually exchanging EUR for USD when a customer goes long a lot of EUR/USD, it doesn’t need to have 100,000 EUR on-hand (putting aside the whole matching up of customer positions brokers do on the back end). It’s not like a stock dealer which actually has to have the capital (or sufficient lines of credit) to own the shares it’s making a market in.
That’s why forex brokers can offer such high leverage ratios.
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
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