Leverage is, in general, a powerful and useful feature of forex trading. It gives you the flexibility to take significant positions on key currency pairs without tying up excessive amounts of capital, and magnifies the size of any profits you might make. However, leverage can be dangerous. If you are wrong about a trade, it acts to magnify your losses.
Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. You could sustain a loss of some or all of your initial investment and should not invest money that you cannot afford to lose. Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. You could sustain a loss of some or all of your initial investment and should not invest money that you cannot afford to lose.
The impact of leverage on your trading
The risk of using high levels of leverage
At excessively high levels, leverage exerts another effect. In addition to simple magnification of P&L, it begins to materially damage your odds of success on any particular trade.
At IG we believe that all our clients should fully understand the impact of leverage, and the circumstances under which it can significantly damage the probability of a trade being profitable.
We also believe that allowing excessively high levels of leverage is not in the interests of our clients, our firm or our industry, and set our margin levels accordingly.
How does high leverage impact your trades?
This graph shows how excessively high leverage acts to distort the probability of your trade being successful. This distortion is the result of the way leverage interacts with transaction costs (spread and funding).
In the absence of transaction costs, the leverage you use has no impact on your probability of success. If you were to place trades randomly, without any particular insight or skill, and aim to take profits of the same size as your maximum stop-loss, you’d tend to win on 50% of trades and lose on 50% trades.
This would be independent of your leverage used, and is represented by the dotted horizontal line on the chart.
Transaction costs change this picture, representing a hurdle between you and a profitable trade. Another way of saying this is that costs shift the odds against you. At most levels of leverage this shift in odds is small.
However, when the leverage you use is so high that the margin supporting your trade is less than 10x to 20x your costs, your probability of losing begins to increase very rapidly. This is because costs eat away at the supporting margin, leading to a high probability of being closed out.
This is easy to understand if you think about the most extreme case, where your supporting margin is exactly equal to your transaction costs on a trade. You’d place your trade, and the transaction costs would leave you with zero supporting margin for your position. This would lead to you being closed out immediately, with 100% probability, every single time – regardless of your trading strategy or how the market moves.
The importance of managing your account when trading
Best trading practice:
In general we advise you not to use the minimum allowable margin as a matter of habit when trading –margin requirements are set to give you flexibility when you really need it, rather than being the level of margin you should always be using in the normal course of trading. Our most successful traders, and longest-standing clients, tend to place significantly more money on deposit than strictly required by the margin rules.
Bear in mind the impact of other costs on your positions, too. Many firms charge higher transaction fees than IG, often in the hidden form of very high overnight funding charges.
The effect of this is to place their clients in the position of having a very high probability of losing on each trade. This ‘churn and burn’ business model sees the firm aim to make money by encouraging its clients to lose, meaning naive traders are treated as a commodity to be quickly and aggressively exploited, before being replaced by newly recruited replacements. We do not believe any forex broker should act in this way. We want our clients to be as successful as possible, so we can build a rewarding long-term relationship.
Our business model is different. We hedge the vast majority of our net client exposure. This means there is no correlation between our revenues and our clients’ overall trading performance, and that there is every incentive for us to support you in your trading with us over the long term.
