Risk & Leverage
As a regulated member of the industry, MF Global FX follows IIROC rules on proficiency, capital adequacy and margin requirements. IIROC has prescribed minimum margin rates for forex contracts that are significantly higher (i.e., more restrictive) than the rates offered by many unregistered forex dealers. As a result, traders with these entities are able to take significantly larger positions and become significantly more exposed to gains and losses based on movement in the price of the underlying currency.
MF Global FX has been trading online retail forex with clients since 2003. In our experience, many traders prefer low margins. Given that online forex trading is generally facilitated with an element of leverage, we should examine whether higher leverage necessarily leads to larger profits. We often hear that leverage is a double-edged sword. Risk disclosures routinely warn that although high leverage may produce significant returns, it could also lead to large losses. So why do many unregistered dealers constantly lower the threshold to entice traders with margins of 0.5%, or even as low as 0.25%?
200:1 or 33:1 - Does Lower Leverage Reduce Risk?
First of all, the prospect of a high payout with a small initial deposit appeals to novice traders who have not adequately evaluated the risks. Secondly, low margin requirements enable traders with meager capital to participate in a highly speculative market where competing investments would require a much larger down payment.
Regulators argue that using high leverage in the forex market lowers a trader’s safety margin against adverse market conditions. These risks are exaggerated by random short term volatility driven by the constant release of financial, economic and political news. They are further compounded by trader psychology that sometimes produces irrational behavior at odds with stated financial goals.
The following illustrates 2 typical traders: Trader A (aggressive) and Trader B (conservative).
| Trader A | Trader B | |
| Equity | $2,000 | $10,000 |
| Maximum Leverage | 200:1 | 33:1 |
| Position in Market | EUR/USD 200,000 | EUR/USD 100,000 |
| Leveraged Contract Value | $300,000 | $150,000 |
| Used Margin | $1,500 | $4,500 |
| Used Margin/Equity | 75% | 45% |
| Pip Value | $20 | $10 |
| Free Margin @1.50 | $500 | $5,500 |
Trader A is a novice trader who is convinced that low margins can produce outsized profits. He has seen promotional materials from an unregistered dealer advertising low margins and high returns. With $2,000 he opens a 100K account with 0.5% margin or 200 times leverage.
Trader B is an experienced trader who is aware of the risks in speculating on the forex market. He takes a conservative approach and opens a mini account with a $10,000 deposit at an IIROC regulated dealer. The account is eligible for CIPF protection, and major currency pairs are margined at 3%.
Both traders buy EUR/USD at 1.5000.
Trader A is determined to get the biggest bang for his buck. He buys a maximum position (2 100K lots) of 200,000 EUR/USD with a margin deposit of $1,500, leaving $500 of free margin to ride out the volatility.
Trader B is more prudent with using leverage in his account. He buys a position (10 mini lots) of 100,000 EUR/USD with a margin deposit of $4,500, leaving $5,500 of free margin to cushion against potential drawdown.
Scenario 1
| Trader A | Trader B | |
| Realized Profit | $2,000 | $1,000 |
| Return on Equity | 100% | 10% |
| Return on Used Margin | 133% | 22% |
Shortly after the positions are taken, EUR/USD rises to 1.51. Both traders close their positions. Trader A realizes a profit of $2,000, which translates into a return on equity of 100%, or a return on used margin of 133%. Trader B books a more modest profit of $1,000, which translates into a less impressive return on equity of 10%, or a return on used margin of 22%.
Trader A becomes the forex market’s poster child for low margin, high leverage and fast profits.
Scenario 2
| Trader A | Trader B | |
| Unrealized Loss | $400 | $200 |
| Free Margin @1.4980 | $100 | $5,300 |
| Price @ MC Liquidation/Warning | 1.4975 | 1.445 |
Not long after the positions are taken, EUR/USD dips to 1.4980. Next support level is at 1.4975. Trader A is 5 pips away from margin call liquidation. Trader B is 530 pips away from Maintenance Margin Warning. Trader A has no room to maneuver. Trader B could test the 1.4975 support level by adding to existing position (because he has sufficient free margin), and exit the entire position if support breaks.
In a drawdown, Trader A would be a typical example of how inexperience and aggressive leverage can impact an under-capitalized account.
The above highlights the effect of leverage on the traders’ accounts during a drawdown scenario. With few exceptions, a trader is exposed to more risk as leverage increases, and his account gets wiped out sooner because it cannot withstand market volatility.
The question traders need to ask themselves is: Even assuming that a correct call has been made on the direction of a currency pair, what are the odds of it moving from price A to price B in a linear fashion, without any temporary setback that may require additional margin funds to cushion the volatility and a potential drawdown?
100:1 or 33:1 - A Different Look at Risk vs Leverage
You would have likely seen the above illustration from those who advocate lower leverage in retail forex. However, one might just as easily argue that leverage on its own does not capture the entire risk profile of the trader, especially leverage as stipulated by regulators in some jurisdictions, and defined as the maximum gearing that a dealer can allow in a trader’s account , which for example may be at 100:1. The margin percentage rate is the inverse or reciprocal of the leverage ratio, which in this example is 1% and it determines the margin requirement of a currency position.
Technically leverage and margin are flip sides of the same coin, but in practice they are not necessarily related to each other in a linearly reciprocal fashion. Regulators argue that high leverage is bad for traders because it allows greater exposure which could lead to greater losses, while traders insist that low margin requirement is good because it ties up less equity in used margin and allows a bigger buffer zone or safety margin.
Both arguments have merit. A novice trader is likely to fully utilize the maximum permitted leverage as he cannot resist the temptation of a high payout with a low down payment. This is probably the trader that regulators want to protect from his own greed. An experienced trader however, sees high margin requirement as an unnecessary intrusion into his risk management. He prefers the flexibility of the permitted high leverage which he will only keep in reserve as a buffer against any unforeseen volatility.
Leverage is only one component of the overall risk picture. Limiting leverage by itself does not mitigate risk. Only stops or draw down limits can control risk. The maximum leverage determines the margin requirement of the trade. For example, let us consider 2 traders each with $10,000 in their accounts. Trader X opening a $100,000 position in a 1% account (100:1 max leverage) would require $1,000 for margin, whereas Trader Y in a 3% account (33:1 max leverage) would require $3,000 margin for the same position.
If the positions in both accounts are protected by a 50 pip stop, then the risk to either account is limited to 50 pips, regardless of the leverage. The difference in leverage comes into play when neither trader uses stops and instead relies only on the liquidation mechanism as stop loss when maximum leverage is exceeded.
In that case, Trader X would be margined out when his equity has fallen by 90%, whereas Trader Y would be margined out sooner, at a 70% draw down in equity. So the higher margin requirement or lower leverage does reduce losses, under some conditions, but especially when stops are not in place.
Although the maximum buying power in a trader’s account is a function of leverage, in the real world hardly any trader, even the most inexperienced, would open an account and immediately leverage his entire equity on one trade. In fact, next to setting stops, the next critical element of risk management is to maintain a ratio between used and free margin that may cushion any unforeseen setbacks if stops were not placed or executed according to instructions.
That ratio may be 50:50, or some other numbers deemed acceptable to the trader based on the currency pair, the margin requirement, and the length of the exposure, etc. This ratio is equally important whether the maximum leverage is 100:1 or 33:1. However, open positions in the account limited to 33:1 leverage ties up more free margin and reaches the critical threshold sooner, handicapping the more conservative trader.
Traders should always trade with stops, because placing stops on open positions is the only way to effectively control risk in most situations. However, since stops are not completely failsafe and not everyone trades with stops, a safety margin should also be maintained between used and free margin in the account at all times.
In the real world many traders utilize only a portion of the free margin as determined by the maximum leverage. In fact, the key would appear to be that one should trade a highly leveraged account as if it were leveraged much lower, so that the safety margin is always available. Some may argue that this safety margin amounts to leaving idle cash in the account. That may be true, but it also means that the account has a better chance to withstand random volatility that might otherwise wipe out others.
The following illustrates the 2 traders discussed above: Trader X (100:1 max leverage) and Trader Y (33:1 max leverage)
| Trader X | Trader Y | |
| Equity | $10,000 | $10,000 |
| Maximum Leverage | 100:1 | 33:1 |
| Position in Market | USD/CAD 100,000 |
USD/CAD 100,000 |
| Required Margin | $1,000 | $3,000 |
| Used Margin vs Free Margin | 10:90 | 30:70 |
| Effect on equity if 50 pip S/L hit | -C$500 | -C$500 |
| Effect on equity if margined out | -$9,000 or 90% | -$7,000 or 70% |
Why is leverage used at all?
Contrary to popular misconception, most major currency pairs in the forex market barely move more than 1 - 2% a day. Even after the release of major economic data markets rarely move more than 2%. Compare that to the stock market where it is not uncommon for some issues to move 15% to 20% after earnings surprises. Furthermore, countries in the developed world do not go bankrupt, and their currencies do not become worthless overnight. One could invest in currencies fully paid up, but it would take substantial capital to produce meaningful returns.
Leverage or gearing is introduced to deploy capital more efficiently. When judiciously applied it could be an effective enhancing tool for an experienced trader to capitalize on opportunities with manageable risk. Its imprudent and excessive use, however, will destroy equity and quickly wipe out any trader who does not properly assess its risks.
