Disadvantages of Leverage in Forex
Most traders who have experienced terminal problems with their accounts have dabbled unsuccessfully with leverage. Most of them will have gotten a little too greedy for their capital to bear, of will simply have made a few critical mistakes along the way. The power of leverage works equally in both directions, whether that happens to be for or against your position, and understanding exactly what impact it can have on your portfolio is the first step towards mitigating against the threats it poses. But how do the risks of leverage factor in to determining how best to deploy your capital?
Heavier losses
First and foremost, leverage is a nuisance because it paves the way for heavier losses. A 0.1% loss on a notional £20,000 at a leverage of 100:1 position (a loss of £20) feels like much more like a 10% loss when you are only exposing £200 to the position in the first place. The effect of leverage is to simply up the ante, so that in effect you’re playing with more money. When all’s said and done you keep the profits but you also bear the losses, and in this respect, leverage can end up costing you a lot more than you bargained for when positions inevitably from time to time head south.
Leverage as a constant liability
Furthermore, leveraging part of any transaction builds in an immediate liability that must be met by your account at the end of the day. No matter whether a transaction is up or down, no matter how many additional costs you’ve paid, the principal cost of the leverage must be met and will be automatically applied from your account. This effectively means that by entering into a position you are by default handicapped, having the automatic liability of the leverage portion to meet at the close of the transaction. Even if the transaction ultimately trends towards zero, the leverage amount is still owed and must still be paid before you can move forward.
Financing costs
As if these troubles weren’t significant enough, any leverage funding that is applied to your positions must also be paid for in terms of interest. Interest is calculated and applied on a daily basis depending on the relevant rate as set by your broker. These costs are obviously all the more applicable with the high degrees of leverage involved in forex transactions, and the costs can mount up to act as a disincentive for holding exposure long term.
Margin call risk
At the same time, there remains the ever-present risk that you will fall below the margin requirements established by your broker. This is the set percentage of any transaction size you are required to fulfil in terms of your own capital, and if you fall below that threshold at any point, you can expect your broker to instigate the margin call, which will automatically liquidate your portfolio as far as meeting your obligations is concerned. This means that positions that might run on to deliver vast profits are closed out early (posing extensive and unavoidable opportunity cost) in addition to liquidating losing positions that might recover. Ultimately, this is a constant risk that is posed by the presence of leverage, and something you should take care in managing your capital to avoid.
While there are clearly a number of disadvantages to using leverage, it is important not to be put off leverage and leveraged trading on the whole. Generally speaking, leverage is considered a good thing, and particularly in forex markets where it makes up for a lack of volatility, it is essential for allowing quick yields.