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Reader Questions Answered

Where does forex leverage come from?

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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Reader Questions Answered

How can forex brokers provide so much leverage?

Margin and leverage in trading are topics that cause a great deal of confusion to new traders. I received yet another question in that area recently, though with a bit of a different twist to it.

On the relationship between leverage and margin: I read that traders borrow money in margin account. In stocks, like in Malaysia, usually the brokerage firm is a subdivision of a bank, so it is the bank who lend the money. But in forex, who actually lend the money? Is it the broker? Does that mean, the broker is really really rich (like, if min leverage is 1:100, so it must have at least 100 times of the deposits of their clients.)?

As this individual noted, in stock trading the institution through which you are trading lends you the money to buy stocks on margin. Generally speaking that means you will have to pay them interest on that loan.

In forex trading things are a bit different. On the one side you are borrowing the currency you are short. That is then converted into the currency you are long, which is then deposited. In all of this you are paying an overnight interest rate on the currency you borrow (are short) and receiving an overnight rate on the currency you deposit (are long). The difference between the two is the net interest carry you will pay or receive.

Now, as to whether the broker is really rich to be able to over this kind of leverage, no. They do have considerable capital (the larger ones have over $100 million in capital), but not the amount I think this person has in mind. Why? Because they are mostly netting out customer positions against each other.

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Trading Tips

Defending Options Trading Against Blogger Attack

A fellow trading blogger wrote some things which really irked me. I’m not going to say who it was or link to the post as I normally do because basically all the guy does is plug his trading system in every post. He’s been on a multi-post rant about how people shouldn’t trade options or futures, or any other leveraged instrument for that matter. Two of the quotes this individual made in one of his recent posts in particular caught my eye.

With options trading, you need really good money management skills and many positions for diversification purposes.

If we took “options” out of the above sentence the first part of it would be fine. Good money management is a requirement of trading in ANY market. As for the requirements for diversification, to the extent that someone is going to diversify, it applies equally to any type of equity trading.

By the way, while investors who plan on long holding periods would do well to diversify their holdings, the same doesn’t necessarily hold for traders. In fact, the latter are better off keeping things concentrated so they can properly track their positions.

Since both options and ultra ETFs are about leverage, it makes more sense to go into ultra ETFs because they’re generally much safer than options and offer similar outsized returns.

I can’t help but wonder how the blogger is defining safety. If it has anything at all to do with the potential to take a loss larger than expected, then the ETFs are riskier than owning options, not safer. It’s a very simple thing. If you buy an option your risk is clearly defined. You can’t lose any more than what you paid. In the case of an ETF, however, you can easily lose more than you intended to risk because even if you use a stop there’s no guarantee of a fill at your exit price.

Now, if the blogger is equating risk to the odds of taking a loss, then that’s a different conversation. I’m still not going along with his take on things, however, because as I’ve previously noted in other posts, win % (or loss %) is not the sole determinant of performance.

I’ve said it before. It’s not leverage that creates risk. It’s how you trade. I personally prefer options for my equity trading because I can strictly define my risk and better manage positions on a running basis, plus they require less capital. That said, however, options suit the way I play the stock market. They will not do so for everyone.

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Trading Tips

Keeping things simple in your trading

Beanieville posted Don’t Let All Those Technical Analysis Gurus Confuse You on Tuesday with the primary suggestion being that one should keep things simple by avoiding derivatives and leverage, and a secondary one to keep your analysis relatively simple. The title obviously only applies to that second point, but I think the general message that less complexity is better for most traders is a good one.

In particular, there’s a quote that goes:

“If you’ve been to some options or futures trading sites most of you probably feel like you don’t belong because of all apparently sophisticated analysis of the market, with so many trendlines and so many indicators you never heard of.”

I’m going to agree with the part about all the lines and indicators all over charts. I see it all the time, even among my professional colleagues. If that’s what works for them, fine, but I’m definitely not a fan. The charts I look at are simple, without all kinds of trendlines, Fibonacci retracement levels, Elliott Wave counts, oscilators and all that. To me the rest of it is clutter which serves no other purpose than to distract and obscure the important part – what prices are doing.

Now, having said that, the idea that options and futures traders are the main culprits here is just plain wrong. I’ve seen stock traders with some of the most intense charts ever. Market complexity does not necessarily equate to analysis complexity. It’s a personal thing for each individual trader. I’ll leave it to them to decide what’s best for them in the end.

The other contention made by Beanieville is that traders should avoid options and futures and leverage (which I presume would include forex as well). I’m mixed in this one.

On the one side, I’ve answered a lot of questions about leverage and margin from confused traders. For many folks it would be best to stick to simpler markets at first, until they have a solid grasp of things from that perspective before taking on leveraged trading.

That said, there are plenty of folks who quickly grasp futures and options and such. I have no problem with them starting in the perceived deep end of the pool, as long as they have a healthy appreciation for the risk side of the equation.

The bottom line for me is that different people are going to be best suited to trade different instruments. Keeping them from trading in that fashion virtually guarantess they perform below their potential.

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The Basics

Being Clear on Margin

One of the things which traders new to leveraged trading sometimes get a bit wrong is margin requirements. This is particularly true where forex is concerned. The margin requirement for a position is based on the value of that position, not on the size of it.

For those in a market like futures this generally isn’t something which gets a lot of thought. Brokers and exchanges set margin requirements. They are based on the value of the futures contracts in question (some base %), but the process is often opaque to us as traders. We just see that the margin requirement on Cotton is $1700 per contract, or something like that.

In forex trading margin requirement percentages are more immediately visible as they are directly linked to the leverage ratio brokers permit us. If we trade at 100:1 leverage then our margin requirement is 1%. That means we need to put up 1% on the trades we make – the value of it, not the size. In some cases that is the same thing. If we were to buy 100,000 USD/JPY then the size of the trade and the value of the trade are the same – both $100,000. If, however, we’re buying 100,000 GBP/USD at 2.00 then the value of the trade, and therefore the basis for determining our margin is $200,000, not $100,000.

It’s a simple mistake, easy to make if one doesn’t stop to think about it.

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Reader Questions Answered

What leverage is really all about

I brought up the topic of leverage a couple months ago in my post How much leverage to use? Wrong question! The general topic of leverage, though, continues to be much misunderstood, so let me take some time to back it down to the basics.

Leverage the control of a position larger than your own funds would directly allow. It’s available in one form or another in basically every market and is accomplished either through borrowing and/or the use of derivatives.

You will see things like 50:1 leverage or 100:1 leverage. A 100:1 leverage ratio means that for every $100 in position value you would be required to put up $1 in deposited funds.

Now margin is closely tied to leverage. Margin is the deposit money used to secure a leveraged position. It is normally expressed in percentages. For example the margin on a position when employing 100:1 leverage would be 1%. At 50:1 leverage it would be 2%. An so on.

There is the additional topic of gearing or effective leverage or real leverage. Those are just different ways of talking about the actual leverage one employs when holding a position. For example, you may be able to trade at 100:1 leverage but if you have a $10,000 account and are trading a $100,000 position you are actually only using 10:1 leverage – meaning your are only controlling a trade 10 times the size of your account.

I think most people get that part of it all.

Here’s where the confusion comes in. I have seen a number of traders say that leverage equals risk. This simply isn’t true.  What is boils down to is this. Allowable leverage tells you one thing – how big you can trade, either in terms of position size or number of positions. That’s it. No more. No less.

Risk comes down to one thing, and one thing only – the size of your position. The larger the position, the greater the risk. It’s that simple, really. High degrees of available leverage certainly allow for larger positions, but they do no require them.

The thing that I think causes the most confusion is thinking in terms of margin and not account size. If you trade at 100:1 leverage you would have to put up 1% margin. That means a 1% move in the market against you would wipe out your margin deposit. If you were trading on 50:1 leverage the same 1% move against your trade would only take out half your margin. That seems like less risk.

Here’s why it isn’t.

Assume a $10,000 account and a $100,000 trade size. For a 100:1 leverage account the margin requirement would be $1000, while at 50:1 it would be $2000. If the market moves against the position by 1%, that would mean a $1000 loss to the account, or a 10% decline in account value. It doesn’t matter whether the trade was done in a 100:1 or 50:1 leverage account. A 1% move on a $100,000 position will always represent a 10% change in account value for a $10,000 account.

The only time differences in leverage mean differences in risk is when you are talking about different position sizes, basically meaning using all available funds for margin. The 100:1 leverage $10,000 account could trade $1 million, while the 50:1 could only go as high as $500,000. Clearly, when the accounts are maxed out like that a 1% move in position value is different. The 100:1 account would be wiped out, while the 50:1 account would only lose have its value.

I hope that clarifies things a bit. Feel free to comment with your own thoughts and/or questions.