Why is leverage high in the forex market? – Trading strategies for intermediate traders
When it comes to financial investing, he covers a wide range of trading tools. Leverage is non-existent in the Chinese A-share market because the price of individual shares is too low. For a 10 yuan stock, the threshold for trading a lot is only 1,000 yuan, which is insignificant for most individual traders.
In the Chinese futures market, the leverage is typically set at 20 times. For example, for a soybean contract size of 2105 units, with a current price of 3185 yuan / ton and a lot size of 10 tons, the minimum transaction value is 31,850 yuan. This amount is sufficient to exclude most individual investors who have small investment accounts.
It was necessary to introduce 20 times leverage to increase market liquidity and allow retail investors to participate. Therefore, to negotiate a similar contract, traders are now required to pay a margin of 1592 yuan, which makes it easier for more traders to participate in the markets. After all, most traders don’t intend to hold contracts to maturity (delivery requires full payment) but want to profit from price movements in futures and spreads.
Why is the leverage in the forex market so high?
Based on the same reasoning, the value of a contract in the forex market can reach 100,000 in the base currency, often the US dollar. Converting 100,000 US dollars to RMB is 700,000 RMB, a level of funding that is beyond the pockets of most traders.
The capital threshold set by the China Council for Scientific and Technological Innovation is 500,000 yuan. However, these thresholds have been widely criticized. In addition, there is a minimum threshold of 700,000 yuan for trading in the forex market.
Many questioned the need for a base currency of 100,000 and wondered whether one should start trading in a range of hundreds of thousands.
The short answer is yes. However, exchange rate fluctuations are minimal in the short term for the forex markets, unlike the stock market which has a daily limit of 10%.
For example, EURUSD had an average fluctuation of 2.22% in 2019, while the fluctuation in 2018 was 4.45%, the fluctuation in 2017 was 13.98%, while that in 2016 was 3.14% and the fluctuation in 2015 was 10.17%.
The highest volatility throughout the year is only around 10%. Given that there are 365 days in a year, one can imagine how low the volatility of a day is. Considering these small fluctuations, investing hundreds of thousands of dollars is unrealistic, as one can go several years without obtaining significant returns.
Exchange rate fluctuations are small because the exchange rate is the foundation of a country’s economic stability. However, if the exchange rate fluctuates frequently, it will cause major disruption in the import and export industry of the country.
In addition, domestic companies often travel to international markets to take out loans. However, if the exchange rate fluctuates sharply, the loan amounts will change drastically with the fluctuating exchange rates, which is not conducive to managing financial costs.
The leverage used in the forex market is between 30 and 200. Leverage of 50 times or less is suitable for institutions, while leverage of 100-200 is suitable for individual traders.
Due to the characteristics of the forex market, traders generally do not use the percentage increase or decrease to measure market volatility. Instead, they use “standard deviation” to measure.
For example, for EURUSD, a standard point is a change of 0.0001 in the exchange rate, or one ten-thousandth. To trade a lot of EURUSD, with less than 200 times leverage, you just need to pay 500 US dollars. For each standard point of exchange rate fluctuation, the trader’s profit or loss is US $ 10. At the end of a typical day, EURUSD volatility is likely to be in the tens to hundreds of points. Hence, traders can make huge profits despite low volatility.
Leverage can lead to extraordinary rewards, but it can also sometimes be damaging. For example, this can lower the trading threshold and allow more individual traders to participate. Yet, it also increases the risks associated with trading, especially when the trader loses money and may owe the broker money.
Many traders view account liquidation as a problem created by too much leverage. However, this has nothing to do with leverage levels. Instead, it has to do with a trader’s risk control strategy.
Two important elements of risk control: position and stop loss
A common mistake made by individual traders is not to set a stop loss when trading large positions, which is the root cause of massive losses and account closeouts.
Even if you don’t use leverage to trade, you will incur larger losses than expected if you enter large positions without having a stop-loss order. Traders always make these two mistakes because they are motivated by human nature.
Everyone wants to invest in the markets to make a quick buck. They lack patience and often place orders with a “gambling” mentality that leads traders to fail. Under the influence of impulsive emotions, traders get emotionally invested in their trades and make bad decisions resulting in massive losses and minimal gains.
Savvy investors know that financial freedom doesn’t come with a single transaction. You have to win many trades over a long period. Traders need to learn how to trade, reduce position, use a stop loss as a habit, and remove the overtrade impulse to be successful over the long term.
The scope of leverage is quite wide, and the issuance of bonds by listed companies is also a form of leverage, but it is called financial leverage.
A 35% down payment is also a type of leverage, and buyers only need to pay a portion of the down payment to own a residential home. Therefore, leverage is not at the center of investment issues. Instead, it benefits those who use it with discretion. However, people need to be careful and apply appropriate risk controls when using leverage. Risk management is a delicate and narrow line, and it is only through direct experience that the user can consistently benefit from it.