Forex trading can be a profitable business, giving traders opportunities not offered by other markets. One of them is leverage, which allows you to trade in large volumes and multiply your profits. But can Forex leverage put you in debt?
Forex leverage can put you in debt if you don’t use it wisely. It can wipe out your account and even make it negative if you lose more than your deposit. The broker may ask you to recover it to zero by paying them the difference. You owe this money to them and may face lawsuits if you don’t pay it.
This article discusses the way leverage works and how it could put you in debt. It also talks about the risks of using leverage and how you can mitigate them.
How Can Leverage Put You in Debt?
Leverage is famous as a double-edged sword. If you don’t use it carefully, you could end up blowing your whole account. But if you trade it wisely, it can bring you huge profits.
Leverage works like borrowing money from your broker. It helps you trade with less capital and larger volume. But when you trade using leverage, you could lose more money than your deposit.
In case of losing a position, the following scenarios may happen:
- If your broker has set up a margin call, you won’t lose more than what you have. A margin call stops your position when your account reaches zero. This way, it won’t get negative, and you won’t owe any money to your broker.
- But if you don’t have a margin call, your account goes negative when you lose money more than your deposit. Then it’s up to your broker to hold you liable to the debt or not. Brokers have different policies when it comes to negative accounts. They state these policies in their terms and conditions:
- Some brokers ignore the negative account and change your deposit to zero, so you can add more money and start trading.
- Other brokers hold you liable for the lost amount. In other words, you owe the broker and have to pay it to make the account reach zero.
What Is Leverage in Forex?
Leverage allows you to control bigger trades than you could normally do with your deposits. Brokers give you leverage on different ratios depending on the trade and account size. The larger the balance, the more leverage they offer.
Suppose you have a 50:1 leverage. Then you can trade $5000 with $100 in your account. Forex trades are executed in lots ($100,000). So, if you want to get a lot in Euro/USD, and you have a 50:1 leverage, you don’t need to have $100,000 in your account. You only need to deposit $2,000.
However, any potential profit or loss will be corresponding to $100,000, not $2000. That’s why leverage is a double-edged sword; You can end up with either profits or huge losses.
How Does Leverage Work?
Although leverage is known as a loan given to traders, it can be a little different in forex.
In other markets, leverage is similar to a credit boost. For example, when you want to buy a house and get a mortgage from the bank, the mortgage is a form of leverage. Also, in the stock market, traders get leverage from the brokers and pay it back. But it’s not the same in forex.
Forex leverage is different from any credit line in that you don’t need to pay it back. It works as a safeguard to make sure you don’t default on your positions. So, you have to keep your position open before a margin call closes it. Thus, when you use leverage, you don’t owe any money to your broker.
Besides, unlike loans, you don’t need to pay any interest on leverage or margin. The only interest you pay is the overnight interest rate or swap, which you may pay for overnight positions. Conversely, in some situations, the broker pays you the interest rate.
What Is Margin?
Margin is the actual amount of money you have in your account. It allows your broker to give you leverage. In other words, it’s the collateral for the loan you’ll receive from the broker.
Forex brokers have different margin requirements depending on the trade size and the currencies. For example, new emerging currencies typically have higher margin requirements. But commonly, a 50:1 leverage requires a 2% margin, a 100:1 leverage requires a 1% margin, and a 200:1 leverage requires a 0.5% margin.
How Can Leverage Hurt Your Trading Account?
If you use leverage and lose money, you’ll lose based on the leverage amount, not your margin. That can wipe out your account, even with one trade. Here’s how leverage can lead to your loss:
When you use leverage, you may feel empowered enough to beat the market. Mainly, it can happen when you have experienced a bad loss, and you want to make up for it by trading more. Leverage can give you a false idea of control over the market.
The same thing can happen after having a winning streak that makes you greedy and overconfident in your abilities. So, don’t let leverage get in the way of seeing things logically and take your time before opening another position using leverage.
Using Too Much Leverage
Forex offers much higher leverage than other markets. While stock traders can get 2:1 leverage, forex can offer up to 500:1, depending on the account size and the broker. However, it doesn’t mean you should use as much as your broker offers you. Overleveraging has led to some countries’ regulations limiting the amount of leverage to avoid huge losses.
The most reasonable amount of leverage is 1:100 and if you’re a beginner, consider even a smaller ratio until you acquire enough trading skills.
Margin Call Risk
As we said, leverage is a percentage of your trade size calculated based on the margin, the money amount in your account. So, you’ll reach the margin call more quickly when you lose a trade with leverage. Your account deposit will turn to zero, and the broker will liquidate your account. It’ll also affect other positions that could have been profitable since all of your positions will be closed.
How to Minimize Leverage Risk?
In addition to taking it slow when it comes to using leverage, you need to consider some common risk management strategies to mitigate leverage risk. The most important one is stop-loss orders.
Setting a stop-loss order helps traders avoid losing all their capital due to different forex risks, including the leverage risk. It means setting a limit for your losses. So, if you start losing money, your broker will stop the trade and prevent you from losing more money when it reaches the set limit.
Plus, read the terms and conditions carefully to understand fully how the broker will execute the leverage and margin calls.
Leverage is a beneficial tool given to forex traders to increase trade volumes with small capital. It works like a loan given to traders by brokers, but they don’t need to give it back because it’s not real money.
However, leverage can put you in debt if your account goes negative, meaning you lose more money than you have in your deposit. In this case, you have lost all your deposit and owe your broker as much as the negative balance.