The Killing Side of Leverage in Forex Trading
How Leverage Can Make a Trader Poor or Rich
Apr 25, 2009
The concept of leverage was extensively described in a previous article entitled Leverage Offered by Forex Brokers. Here, it is aimed to emphasize the importance of leverage in online trading, and how to manage it to avoid possible bankruptcy.
How Leverage Kills a Trader?
In any business, one may lose or win; in a common business, one has a chance to lose to learn how to win. The case is different in forex trading for losing by leverage. When a trader loses according to an inappropriate management of leverage, he loses almost everything, which normally leads to bankruptcy.
This is indeed the dangerous part of forex trading. For a successful trading (both forex and stock), one needs a constant success in the course of time, because forex trading is not a one-time game to win or lose everything. One may lose everything by leverage, but cannot win everything in a single trade.
In a trade with high leverage, a trader may lose or win 100% of his capital (see the example given in Leverage Offered by Forex Brokers). Upon failure, he has lost all of his capital and cannot continue to trade; in other words, he has lost everything. But, if he wins, the gain is just 100% of his initial capital (e.g., not everything), and he needs to trade more for earning money for expenditure.
Thus, a safe trading strategy is to keep the possible profit or loss limited to few percentages. Although almost everyone knows this fact, most of traders simply ignore it, due to greed and temptation.
Leverage Is Enticing
People usually believe that inappropriate management of leverage is limited to amateur traders, and professional traders are wise enough not to make mistakes. It is interesting to know that the current banking crisis is indeed due to the inappropriate management of leverage. The investment banks used high leverages (e.g. 1:40) to buy securities.
By analyzing the past years, they had concluded that the market is stable enough not to use their available margin. However, the global economic crisis caused an unusual change in the market (c.f. Major Changes in the Forex Market during 2008). It was a rare event, but possible. When dealing with everything, a trader should always consider all possibilities, even less probable ones.
Supporting Fund (Loan)
Leverage-based loss is due to a temporary price movement in the opposite direction, not a wrong trade. Thus, the trader can win with profit if surviving in the crisis period. To this aim, the banks are surviving with the governmental aids, and supporting funds provided by loans will back them up to handle the crisis.
A conservative trader also should find a guaranteed source of an available fund when relying on leverage. Not using a profitable leverage is not wise, as the economic crises only occur rarely. On the other hand, losing everything due to a high leverage is not wise either. Thus, an experienced trader can earn much profit with a high leverage (of course, not extremely), but with efficient arrangements for rare events.
For instance, he should always have a source for getting a loan easily. The type of loan is not very important, as it will be used on rare events only, but it should be guaranteed that the loan is always ready upon request.
It should be emphasized that this solution is only for the temporary crises when a high leverage leads to the trader’s bankruptcy, assuming that the trade is not wrong. In other words, the trade is profitable upon handling the crisis; otherwise, the lent money will also be lost.
Analysis of the Current Banking Crisis
Banking's Crisis | Paradise Lost
High Leverage Has Brought Down the Whole Banking Industry
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