Forex Trading Leverage and Costs

Many people would like to trade for a living, but the biggest problem they face is a lack of capital. In order to make a living trading in the stock market, traders really need to plan on having an initial balance of at least $100,000. That’s possible for mid-career professionals and retirees, but an unlikely amount for a younger person just starting out on their career path. Even with that much money, they’ll need to use leverage in order to shoot for profits of $1,000 a week on average. This would be equivalent to an hourly wage of about $25 an hour, which seems like a good minimum target for traders.

Looking beyond the stock market, trading for living with a small amount of capital is possible. It will require studying and learning about the markets. Either futures or foreign exchange markets can work for small traders, with foreign exchange being the market of choice for the smallest traders. Options also offer potentially high rewards for a small amount of capital, but very few traders have found success in options. Futures and currency trading are designed to allow participants to put a small amount of capital to work, and they seem to offer the best chance of success. Options were originally used as hedging tools for market makers and in many ways, the options market is still easier to trade with large accounts.

Foreign exchange, or FOREX, offers a high degree of leverage, and some brokers will let traders open accounts with only a few hundred dollars. With a $500 account and fifty-to-one (50:1) leverage, traders can start out with positions worth about $25,000. Some currencies are limited to 20:1 leverage, but that would still represent positions totaling $10,000 in a $500 account. FOREX brokers are quick to point out that there are no commissions in their markets, so all of your money goes to work for you.

This sounds like a good deal, almost too good to be true and in the investment world, if it sounds too good to be true, it usually ends badly for the individual investor. We need to think about both parts of this good deal – high amounts of leverage first and then we’ll turn our attention to the real costs of no commissions.

Leverage is a double edged sword and is just as likely to lead to large losses as it can to big gains. At 50:1 leverage, a fully leveraged account is completely wiped out with a 2% loss. Daily moves of that size in currencies are unusual, but not unheard of. The Swiss franc/US dollar currency pair traded with a range of that size for nine straight days in August 2011. That was the first time that pair saw ranges that large since the end of 2008. While many currencies saw moves of that size in August, the Japanese yen did not, but it had experienced that degree of volatility as recently as March. The point is that 2% swings are unpredictable on a daily basis and could wipe out your entire account equity in a matter of hours; a 1% swing against your position would lead to a 50% loss of equity in a fully leveraged trade.

Futures trading also offers leverage, but usually only at levels of 25:1 or 30:1. While this degree of leverage is still substantial and offers enough buying power to make a living from trading, margin requirements of about $2,000 to $5,000 per contract make futures less accessible to novice traders. Futures contracts also carry commissions, making them appear more expensive than the free trades available to FOREX traders.

It is possible to scale back the leverage in FOREX accounts, and reduce the risk of catastrophic ruin. A $500 account size at an average level of 25:1 leverage still controls positions that could be worth up to $12,500. This is a reasonable account size, but is FOREX really free to trade?

Not surprisingly, commission free trading actually does carry a cost. FOREX brokers make money by capturing the spread, which is the difference between what you can buy and sell at on each trade. Spreads can be as small as 2 pips, which is paid on each side of the transaction. A pip is the smallest move that a currency pair can make, and the dollar value of a pip depends on the prices of the currencies being traded. To put real dollars to the idea, we can assume that a spread of 2 pips adds up to about $4 per round trip on a $10,000 position assuming the positions are trading near parity. Spreads vary among different brokers, and the spreads can easily be found on their web sites. Also, it’s very important to remember that the advertised spreads show the minimum spread in a currency pair. The typical trade usually takes place with a slightly larger spread. This is all disclosed by the broker, but may require reading the footnotes in the account opening documents. Typical spreads may be two or three times more than the “as low as” rate advertised in large print on some broker web sites.

Realistically, a spread of 5 pips should be used for planning, an amount equal to about $10 per round trip. Most brokers advertise rates that are lower than that on the major currency spreads, and many trades will be executed at less than 5 pips. However it’s always best to assume higher trading costs in testing to see how the system would perform under stressful market conditions.

FOREX accounts are targeted at short-term traders, generally day traders who will be in and out of a position in a matter of several hours. Except in the most volatile markets, this makes it difficult to attain large profits on any single trade. Looking at charts, we can see that currencies do trend for extended periods of time. This is expected since the price of money in an economy will be based upon the long-term fundamentals of that country and these fundamentals play out over many years. The Swiss franc gained more than 30% against the US dollar in the first seven months of 2011 through a series of small daily moves, and traders could realize the larger gains only by holding positions for several weeks at a time.

While the big money comes from long-term trades, if you hold a position overnight brokers will charge rollover rates that will impact the value of your trading account. Rollover rates result from the fact that different currencies carry different short-term interest rates depending upon the fundamentals in each country. With each FOREX trade, you are going long one currency and short another. The difference in the interest rates will be added to or subtracted from your account. These interest rate differentials are often overlooked when testing FOREX strategies and can even be overlooked when setting up an account.

Policies on rollover fees vary by broker. Some policies are more favorable to individual investors than others so they need to be an important consideration when selecting a broker because they can have a large impact on the cost of trading. In effect, rollover fees are the difference between the interest rates of the currency you bought and the currency you sold. If you bought the currency with the higher interest rate, you should be paid the rollover amount on your position. Buying the currency with the lower interest rate means that you will pay the rollover fee.

Based on the different broker policies and the myriad possibilities associated with FOREX trades, it is best to assume that rollover will represent a cost to you when testing a strategy. Although these costs seem to be very low, and they are when looked at for a single day, they can make a difference in profits for traders who hold positions for several days and they will have a significant impact on positions held for weeks. As an example, even a trivial rollover cost of 0.5 pips per day will add up to 2.5 pips for a week long trade. Swiss rates are less than US rates, so rollover fees would lower the returns from a long trade that showed theoretical gains of more than 30%. Australian interest rates were more than 4.5% higher than US rates, making that currency very expensive to short overnight with a rollover cost of more than 1.2 pips per day possible.

All in, costs to trade overnight positions in FOREX rival the cost of trading futures at a deep discount broker. With account balances of $10,000 or more, futures should be considered as a trading alternative. For accounts below that amount, FOREX mini accounts probably make the most sense and in fact are probably the best alternative.

Even with high leverage, it is difficult to make profits with very short-term trades. It’s possible, and some have done it. More traders have succeeded with long-term position trading. You can hold FOREX trades for an extended period of time if you’re properly capitalized, which means leverage should be less than 30:1. It is also very important to know and understand all of the possible costs before placing a free trade. Unexpected fees can cause an account to underperform, while planning for all of the trading costs can help FOREX traders with small initial balances grow into large traders.

By Michael J. Carr, CMT