I truly appreciate this forum. You guys have helped me plenty thus far.
I’m very clear on the formula for margin: It’s the inverse of leverage. More simply, the higher the leverage, the smaller the margin requirement - but that puzzles me. As I understand it, the more leverage you use, the more money the broker or market maker lays on the line: the more you win, the more he loses. If that’s the case, why would he require LESS margin the MORE money he lays on the line, and not MORE margin for the MORE money he lays on the line?
hello WMF,
margin (or used margin) is the amount of $ which is kept from a broker (let’s say frozen funds from your account balance) in order for you to trade with a leverage. You are correct in terms of “the higher the leverage, the smaller the margin requirement”. Brokers just offer higher leverage so with a smallest required margin a trader will be able to open more and more positions/trades.
The higher the leverage the higher the risk. You can win big or you can lose big. Brokers count on the fact that you will either lose big or even if you win, you will taste the honey and keep trading. In the longrun not too many traders will have profits.
I hope i explained and clarified your question about MARGIN. If sth is not clear let me know.
Nicos is right, for the most part.
Why do you think almost every single FX broker outside of the US offers leverage over 50:1?
I’ve seen 1000:1.
Look, it’s no secret that the majority of traders are simply not going to make money over time. They may take profits here and there, but in the long run the wheels will come off. Offering that type of leverage allows individual traders that are severely under-capitalized to get their fix off trading, whilst not pricing them out of the market.
[B]1.[/B] Your understanding of the inverse relationship between margin and leverage is correct [I]in most cases.[/I]
This may come as a surprise to you —
There is at least one broker, YouTradeFX, which offers substantial leverage, but requires NO margin (on accounts up to $100k).
Here’s a screen-shot of one of their webpages —
In other words, at YouTradeFX, there is NO relationship between margin and leverage.
How can that be?
We can think of it this way: Zero margin [I]implies[/I] infinite leverage. However, infinite leverage is a ludicrous concept. So, YouTradeFX is saying, in effect —
“We are not requiring margin, but we are capping the maximum allowable leverage offered at 500:1”.
So, now we need to refine our understanding of how margin and leverage are related. We need to realize that [I]the inverse relationship[/I] between margin and leverage is commonly stated in an over-simplified fashion (leverage = 1 ÷ margin percentage). It should be stated this way:
[B]leverage </= 1 ÷ margin percentage[/B]
(that is, leverage is less than, or equal to, 1 ÷ margin percentage)
Note that leverage [I]cannot be greater than[/I] 1 ÷ margin percentage.
The reason for this should be obvious: If your broker requires margin (as most brokers do), that margin represents a percentage of your account which is not available to cover losses in your position. Clearly, some multiple of the margin percentage would equal 100% of your account. For example, if margin is 2%, then the multiple is 50, because 50 x 2% = 100%.
If you were to leverage your position to 50 times your account balance, then 100% of your account would be committed to margin, and 0% would be available to cover the spread and any losses which might occur. At this point, your position would be untenable, and you would face an immediate margin-call. So, as a practical matter, actually using 50:1 leverage (in this example) is impossible, and therefore using more than 50:1 leverage is impossible, as well.
[B]2.[/B] When you talk about your broker “laying money on the line”, you may be making a conceptual error. Your broker does not put up any portion of the notional value of your position, [I]and neither do you.[/I]
If, for example, your position is one standard lot of USD/JPY in a USD-denominated account, the notional value of your position is $100,000. But, nobody — neither you, nor your broker — actually puts up $100,000, or any portion of $100,000.
Instead, [I]you place a bet[/I] on a position which happens to have a notional value of $100,000. And [I]your broker accepts that bet;[/I] that is, he takes the other side of your bet. If you are LONG, then he is automatically SHORT. He may hold his side of your bet (as a naked position), or he may offset (hedge) it, by entering a 1-lot LONG position with one of his liquidity providers (banks).
But, regardless of whether he offsets his exposure to your position (your bet), he remains your counterparty in this trade. So, by definition, if you win, he loses — not the $100,000 notional value of your position, but the [I]change in value[/I] in that position. If your broker has offset his exposure to your position, then his loss to you is exactly offset by his gain from his liquidity provider, and his net P/L on your trade is simply the spread.
In the example above, your profit, and your broker’s loss, is some fraction of the $100,000 notional value of your position. Let’s say that you hold your LONG position for a 10% appreciation in the value of the USD/JPY. That’s a $10,000 profit for you, and (nominally) a $10,000 loss for your broker.
However, your broker is fully hedged (having offset your position with his bank), and he collects $10,000 from the bank (offsetting his loss to you). So, your profit (his loss) [I]does not represent actual risk[/I] for your broker. Rather, his risk is represented by the possibility that your position will result in a major loss (for you) [I]which exceeds the value of your account.[/I]
Margin is designed to protect a portion of your account from loss, by forcing closure of a losing position before all of your account has been wiped out. This protects you from having your account closed, and it protects your broker from the chore of collecting a negative-balance debt from you.
YouTradeFX claims to accomplish this same protection (for their customers and for themselves) by “guaranteeing stop-losses”. Obviously, this can only happen if their customers are required to place and maintain appropriate stop-losses on all trades.
If YouTradeFX were a U.S. broker, they would be compelled (by the CFTC) to require [I]at least[/I] 2% margin on major pairs, and 5% margin on so-called exotic pairs. It’s worth pointing out that the CFTC dictates margin requirements, not leverage limits. In fact, CFTC regulations never mention leverage.
But, as we have said above, a margin requirement automatically places a limit on allowable leverage.
I hope that, somewhere in the wall-of-text above, you find the answers you are looking for.
Thank you, so much, for your “wall of text,” for which I am grateful; but before I ask some questions about that, perhaps you can toss me your reply to this one, the answer to which is significant to me: Do you agree with what others have said, that the higher leverage/lower margin setup is an inducement to get traders to trade recklessly so they will finally blow their whole accounts (minus margin)?
Now, get out your Alka-Seltzer because there’s plenty coming:
As in the past, your extensive “wall of text” has added to my treasury of information, for which I am grateful. Of particular significance is the fact that the broker has the option of offsetting my bet - (did I express it correctly?) - by hedging, that is, by placing the exact same order that I did with his liquidity provider. Does that mean that he borrowed from his provider? If you can explain to me the basic steps in hedging, it would help clear things up.
So the broker has two options: taking the opposite side of my bet, or hedging. Similarly, there are two possibilities for my bet: win and lose. Altogether, then, there are four possibilities:
He takes opposite side of my bet, and I win.
He takes opposite side of my bet, and I lose.
He hedges, and I win.
He hedges, and I lose.
Let’s look at the four cases. Please consider what I seem to understand, and my questions. Please consider providing your answers within my text, or else number your answers: Either one would make it clear to me what you’re responding to:
He takes opposite side of my bet, and I win. Does the loss come out of his brokerage?
He takes opposite side of my bet, and I lose. Money is transferred from my account to his.
He hedges, and I win. Because of his hedge, his would-be loss would be offset by his parallel win. - But win from whom? His liquidity provider?
He hedges, and I lose. Therefore, we both lose! What happens here? Is his loss a “virtual” loss and mine a real one, meaning that he simply collects from me?
By your own words, you sent me a “wall of text.” I hope I’m not sending you a “wall of misunderstanding” for you to deal with!
Another question: Suppose the broker offers an outrageously high leverage, say, 3000:1, as some outfit in the Middle East does. That means the trader fronts an outrageously low margin amount. Now, suppose the trade moves against the trader and, because of a price spike immediately before a margin call is issued, he ends up owing more than his margin amount. (Seems possible.) Then what? This again relates to my original puzzlement about the whole matter of the inverse relationship between leverage and margin.
With great appreciation,
Norm (Yes, I have a real name!)
There are three ideas rolled into that statement. Let’s look at these ideas, one at a time:
B[/B] High allowable leverage (i.e., low required margin) attracts reckless traders, and/or makes otherwise prudent traders become reckless.
There may be some truth in this one. High leverage in a forex account, like high horsepower in a car, can get certain people into trouble. Leverage is a form of power. And, like every other form of power, it can be abused.
Most parents would not buy a 435-HP Mustang GT for their 16-year-old son. But, nobody would suggest that high-horsepower “muscle cars” are offered for sale as an inducement for reckless drivers to cause mayhem on the road.
The 16-year-old with the over-powered Mustang might say, “What’s the point of having 435 HP, if I can’t use it?” And some so-called forex traders, who act like 16-year-old boys, might say, “What’s the point of having 1000:1 leverage, if I can’t use it?”
The fact that some people might abuse powerful things — high leverage, high horsepower, consumer credit, guns, powerful pain-killers, etc. — doesn’t make those things evil (and isn’t a rationale for banning those things).
B[/B] Brokers offer high allowable leverage with the express purpose of encouraging reckless trading.
This is totally false. Brokers benefit from [I]high-volume trading, not from reckless trading.[/I] No sane broker would encourage reckless trading.
Leverage exists in the retail forex market for one reason: If retail forex trading had to be done [I]without leverage,[/I] there would be no incentive for speculators (which is what we are) to participate.
Prove this to yourself by running a simulation of a trade without leverage. Let’s suppose you have $1,000 to speculate with. You choose to go LONG the GBP/USD at 1.5000. And your trade is successful, earning 200 pips.
Considering this simulation, right off the bat, you realize that the largest position you can enter is [I]only 2/3 of a micro-lot[/I] (666 units of GBP/USD worth $999). If you crunch the numbers, you will find that a great trade (200 pips) earned you a measly $12.32 Was it worth it? In a no-leverage account, would you even bother trying to earn 25 pips? or 50 pips? Probably not.
So, retail forex trading is viable only with the multiplier effect of leverage. This makes leverage an important feature of retail forex accounts, and therefore a valuable selling point in the marketing of those accounts. And, because it can be marketed, it’s subject to the same “more is better” sales pitch that characterizes most advertising.
Offering leverage (up to some maximum limit) does not require margin (as we saw in the YouTradeFX example). But, regulators (like the CFTC) demand margin (earnest money, good-faith deposits, skin in the game) from retail traders who do leveraged trades. Required margin automatically places a cap on the amount of leverage which can be offered and/or used (as discussed in my previous post).
B[/B] Brokers try to make their customers blow up their accounts.
This is false, as well. The only entity which would benefit from making customers crash and burn is a bucket-shop. And here, I’m using “bucket-shop” in its true, classical meaning. A bucket-shop is a type of scam in which the scammer masquerades as a broker, while having no financial connection to the true market. The relationship between a bucket-shop and its customers most nearly resembles a heads-up (2-person) poker game, in which the bucket-shop is one player, and the customer is the other. Every dollar the customer loses becomes a dollar of profit for the bucket-shop; and a total wipe-out of the customer is a total win for the bucket-shop. A bucket-shop can be bankrupted by a successful customer. Therefore, it is very much in the bucket-shop’s interest to use every available trick to make every customer — and especially the potentially-profitable ones — not only lose, but lose everything.
Fortunately, bucket-shops no longer exist, except in certain third-world countries. Don’t be confused by various losers and malcontents who throw around terms like “scam”, and “bucket-shop”, every time they are dissatisfied with the outcome of a trade, or have some dispute with their broker. These losers know that bucket-shops are scammers — but, beyond that, they have no idea what a bucket-shop is. They simply show their ignorance by using such terms.
Let’s divide legal, reputable brokers into two broad categories: dealing-desk brokers, and no-dealing-desk brokers. We’ll come back to dealing-desk brokers in a moment.
• No-dealing desk brokers (essentially STP brokers and ECN brokers) cannot profit from their customers’ losses, simply because their business model involves the immediate offset, or transfer upstream, of every customer transaction. STP brokers offset every transaction (entry or exit) upstream with one of their liquidity providers (banks). ECN brokers transfer every transaction upstream to their ECN, where it is matched against an equal-and-opposite order from another entity.
• Dealing-desk brokers (primarily market-makers), on the other hand, are most often the target of statements like the one at the top of this post, because they have the capacity to profit from customer losses. We need to dig into this.
To simplify the image, let’s imagine that a dealing-desk broker has one guy who receives every incoming customer order, decides whether to take (and hold) the other side of that trade, or to offset it upstream. And let’s imagine that this guy is a total genius: he knows in advance which trades are going to be winners, and which are going to be losers. His job now is simple: if an incoming order is “destined” to be profitable for the customer — offset it upstream. If an incoming order is “destined” be a loser for the customer — hold it. What the dealing-desk guy has just done is this: He has captured all his customers’ losses as profits for the brokerage; and he has passed all his customers’ winners upstream, where they will become losses for the bank. Nifty, eh?
The customers are not hurt, in the least, by this sifting of winners and losers. Every customer’s profits and losses will accrue to his account in exactly the same way as if he were dealing with an STP broker, or an ECN broker. But, our hypothetical dealing-desk broker (with his genius trader on the desk) earns much more than he could if he followed an STP/ECN business model, because he captures, not only spreads, but customer losses, as well.
So, why do many traders cry “foul”, and rant about the “conflict of interest” between dealing-desk brokers and their customers? Well, it’s because of the suspicion that a dealing-desk broker is manipulating spreads and slippage, in order to force the closure — at a loss — of some open trades. The suspicion, of course, is that[I] if a broker can do this, he will do it.[/I] That suspicion may, or may not, be rational. Browse Oanda’s website, when you have a chance, and notice the lengths they go to, in order to assure everyone that they do not intervene, either manually or by computer algorithm, in customer entries or exits.
[I]If[/I] a dealing-desk broker were inclined to manipulate his customers’ open trades into [I]closed losers,[/I] would it make sense for him to totally destroy his customers’ accounts? No, that would make no sense. Remember, this broker is good at offsetting the losses resulting from his customers’ winners, and capturing the profits resulting from his customers’ losses. Common sense dictates that he keep this game going. In order for this broker to capture lots of profits (from his customers’ losses), he needs to keep them in the game. That means they need lots of winners (with the bank taking the hit each time), and they need accounts that grow over time, so that they don’t become disillusioned and move to another broker, or quit the forex market altogether.
It’s a shifty, desperate dealing-desk broker, indeed, who would “try to make his customers blow up their accounts”. Such a broker would likely be throwing up red flags all over the place, right from the get-go.
Essentially, yes. When your broker offsets your trade, he deals with a bank with whom he has a pre-arranged line of credit. That line of credit makes split-second transactions possible (between broker and bank), without the need for making an individual payment arrangement each time. Your broker pays for the use of his line of credit, and each use constitutes a type of loan.
Also, note the fact that your trade (with your broker) is leveraged, possibly highly leveraged; but, your broker’s offsetting trade with the bank is a cash deal, at full notional value. That is, you may place a one-lot trade (worth $100,000) with your broker, posting only 2% or 3% margin. But, your broker uses $100,000 of his line of credit with the bank, in order to offset that trade.
A lot of the answer to this question has already been woven into the discussion above.
But, we can list the steps this way:
• You place a trade with your broker. Let’s say it’s a market order for LONG one lot of XXX/YYY.
• If your broker is a no-dealing-desk broker using an STP order-handling protocol, his computer algorithm immediately mirrors your order to whichever bank is currently offering him the best (lowest) ASK price. That is, your broker places an order to go LONG one lot of XXX/YYY at the best price currently available.
As always in a LONG trade, you “buy” at your broker’s ASK price, and your broker “buys” at the bank’s ASK price.
• If your broker is a dealing-desk broker, his computer algorithm will first decide whether to offset your trade. If the algorithm decides not to offset, then nothing more happens. If the algorithm chooses to offset, then the process may be identical to the one for the no-dealing-desk broker.
Or your dealing-desk broker might choose to offset your trade internally against an equal-and-opposite order from another trader.
Finally, your dealing-desk broker might offset an aggregate position, in order to balance his books: if he finds that he is over-exposed LONG the EUR currency, and over-exposed SHORT the JPY currency, then he will “sell” the appropriate quantity of EUR/JPY to correct his over-exposures.
Yes.
Yes.
Yes.
In this case, you lose x-number of dollars [I]to your broker,[/I] and your broker loses x-number of dollars [I]to his liquidity provider.[/I]
A hedge is a hedge. If your broker is hedged, then whether you win or lose, he breaks even.
The scenario you have described is not only possible, it happened in dramatic fashion in January of this year. Do some reading on the Swiss National Bank debacle on January 15, 2015. There were numerous cases of traders suffering negative balances. Not all of them were “over-leveraged” (note that “over-leveraged” is a very subjective evaluation). But, generally, the traders most devastated by the SNB crisis were the traders who were most highly leveraged.
Some brokerages took a major financial hit in the wake of the crisis. Some have failed. Some have aggressively pursued their negative-balance customers. Some have forgiven negative balances suffered in the crisis.
Ironically, the brokers who survived the crisis in the best financial shape (some even profiting from it) were the so-called “market-makers” — that is, dealing-desk brokers. Some commentators have suggested that this calls into question the wisdom of the STP/ECN business model — that is, the business model of the no-dealing-desk brokers.
Very many thanks for the very clear and exhaustive way you answered my questions. I studied you two posts intensively, and have filed the new understanding I received in my notes and in my mind. Great stuff!
