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Benefits of Higher Leverage

Much of the discussion on leverage and margin has been already covered in our article entitled Leverage, Lots and Margin, but we will review here what is important for choosing a broker.  

In Forex, all transactions can be conducted via standard, mini, micro or sometimes as low as nano or penny size. Each lot size accounts for a different measure of units of the base currency, which in turn presents a different pip value (1 pip = $10 for standard, $1 for mini, $0.10 for micro and $0.01 for nano lot). The leverage offered by the broker affects the margin needed to open 1 lot of standard, micro, mini or nano, as the table illustrates below: 

Leverage % of margin needed
to open 1 lot
$ Amount Required for 1 standard
lot ($100,000)
$ Amount Required for 1 mini
lot ($10,000)
$  Amount Required for micro
lot ($1,000)
$ Amount Required for 1 nano
lot ($100)
25:1 4%
$4000
$400
$40
$4
50:1
2%
$2000
$200
$20
$2
100:1
1%
$1000 $100
$10
$1
200:1 0.50% $500 $50
$5
$0.50
400:1 0.25% $250 $25
$2.5
$0.25
 
What would be the potential risk and Reward of choosing a broker offering a higher leverage than another?

Most articles discussing leverage and forex warn against brokerage firms offering leverage ratios greater than 100:1. What is behind these warnings? It is often the implicit view that the typical retail client is a greedy dumb ignoramus who will probably max out the leverage potential, if given the chance. The leverage in this case is like rope, and when the client is given enough of it, he hangs himself upon it. He sees that his 400:1 broker will allow him to trade 100,000 units with his $300 account size, and so he takes advantage of that allowance, overleveraging his little account to a quick death.

Before 2010, it used to be that US brokers could offer leverages of 100:1 or 200:1. Not anymore. The overprotective US government (via the arm of the CFTC) has deemed the typical US client to be a greedy dumb ignoramus and so in 2010 it acted to protect the forex investor from himself by forcing all US brokerages to comply with a maximum leverage of 50:1, a rule that went into effect in October 2010. Patronizingly enough, the CFTC wanted to reduce leverage to 10:1 to take the "gambler" out of forex, but in the end decided that 50:1 was more "reasonable" and more in line with Japan's leverage regarding forex.  Now the US restrict leverage to 50:1 and Japan restrict leverage to 25:1, while most other countries have higher leverage. 

Overall, I think that restricting the choices of US traders is very bad business and not competitive with the rest of the world. Many former US retail traders have ended up moving their accounts overseas to enjoy forex without as many restrictions. The Brits, Aussies or Swiss will not be so quick to shoot themselves in the foot, when by NOT following the U.S. they can generate millions in additional income. This limitation in US leverage is just one of many limitations (e.g., the non-hedging rule), that did not nothing to help traders and did more to restrict their ability to earn more in the U.S. It is self-righteous, patronizing and paternalistic arrogance on the part of US government regulators to think that 50:1 leverage is "good enough" for the average forex trader. 

The real truth of the matter is that high brokerage leverage in and of itself is not dangerous. Because forex leverage does not change the value of the lot, and because you have a choice to trade different lot sizes, it is not necessarily more risky to have more leverage, as it would be with futures, where you cannot change the lot size. Higher leverage just confers the ability to trade larger lots (or more lots) with less capital. If you had only $500, for instance, you can open up a micro account with 400:1 leverage, so that you can control up to 20 micro lots with only $2.5 margin for each. Or, you can control 1 micro lot with just a $2.5 margin. In between your minimum and maximum use of leverage and lot sizing is a vast range of flexibility.

I agree that having more potential for leverage can be dangerous for greedy traders, but every greedy trader should have a chance to hang himself and remove himself from the marketplace. If a greedy trader has $1000 in his 400:1 micro account, and he wants to use the maximum possible leverage for his trade, he can open 3 standard lots on his account (with a used margin of $750), and gamble his way to a quick death. A very small 30 pip move against his position would cost him $900 (10 X$10 per pip X 3 lots), and at that he would automatically receive a margin call that would liquidate his 3 standard lots because he no longer had the required margin to control them.

The flexible leverage AND flexible lot sizing conferred by Forex can allow most traders a far safer trading arena than either stocks or futures. A futures trader must use the leverage geared for the contract specified, which can be quite high and dangerous. A Forex trader, in contrast, can safely trade lots and leverage in proportion to his account size. For instance, a safe starting trade size for an opening account of $1000 would probably be a micro lot, which would effectively be using zero leverage. The trader would then not have to worry about a 100 pip move decimating his account; instead, 100 pips against him would only cost him $10 (or 1% of his account), which would in turn enable him to ride out a number of losing trades.

Such a trader can then reserve the potential 200:1 leverage for diversification, opportunity or emergency. Let us go over each one.

By diversification, I mean the potential to have concurrent trades that employ different strategies on different markets. Perhaps you created or found six distinct EAs that have great results in back and forward testing, and you want to have the ability to trade all six EAs, using 2% of free margin for each.

By opportunity, I mean that there may be times in the market when you discover an amazing opportunity and you want to capitalize on it with greater leverage or more positions. If you think that the odds are greatly in your favor, the leverage is there for you to use. You have the potential to strike big and hard.

Then there are the cases of hardship. You have suffered a huge series of losing trades, and your account is down $500 from its initial $1000 (50% loss), well then in that case you can still continue to use 0.01 lot sizes to get you out of the hole, but your leverage has grown in the interim, because 0.01 lot size effectively controls $1000 when you now have only $500 (you are now using a leverage of 2:1 respective to your account size). In fact, because of the 200:1 leverage potential, your account can fall below $100 (90% of your initial), and you can still be using 0.01 lot size to try to get you out the hole. The greater leverage capacity is thus allowing you to maintain your initial lot sizing as your account drops. Compare that to stocks, where every percentage decline in your account would force you to trade 100 block shares of smaller and smaller stock values, which would make it harder and longer to climb your way out of your draw down.  

In the end, your brokerage leverage determines your maximum potential leverage, and it is in your best interest to trade the smallest degree of it, reserving the rest for plays of diversification, opportunity and hardship. Thus, brokers that offer more leverage can give you the flexibility and freedom to enjoy some of the potential power of forex trading, when the need arises, despite you having a smaller account size. 

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