Use of Leverage Can Result in Huge Losses for Retail Investors & Traders

Leverage trading

Leverage trading allow traders to open a large trading position, using a small amount called the ‘margin money’.

Trading using leverage has high risks which are highlighted by huge losses for investors & brokers going under when things go wrong. But still many retail traders ignore these warnings & use excessive leverage.

Leveraged trading by definition allows retail traders to multiply trading capital & potential profits. This is because you are using money borrowed from your broker to trade. This multiplication of trading capital could lead to very high losses as well as profit on the part of the traders.

A Double-edged sword

Warren Buffet had this to say about leverage: “really the only way a smart person that’s reasonably disciplined in how they look at investments can get in trouble is through leverage”. Those who know a lot about leverage trading will tell you it is as dangerous as it seems good.

Leverage is often called a two-edged sword.

Leverage can be equally profitable if the price moves in your direction as it is dangerous if it goes against you; because it can exacerbate your losses if the trade does not go your way. This is because your trading capital has been increased way beyond your initial deposit.

In trading with leverage, you can lose your capital in a matter of seconds if the trade moves against you. Many brokers offer leveraged instruments such as CFDs, options and futures. They also offer leverage on stock trading.

However, for buying stocks on leverage, you have the option to deposit securities or cash as collateral for the loan and the stocks you purchase, serve as additional collateral. The stock will be used to pay the broker if the market does not go your way.

Restrictions on Leverage

Given the risks, multiple Tier-1 regulators have restricted the leverage which CFD brokers can offer to retail traders.

In 2019, ESMA published restrictions on leverage to protect retail traders from leverage risk. Similar restrictions were imposed by FCA In the UK.

The Financial Conduct Authority (FCA) for example have adopted the following restrictions for Contract for Difference (CFD) & CFD like options:

  • Leverage for CFD & CFD like options has been restricted to between 30:1 & 2:1 depending on underlying Asset volatility
  • Brokers are to close customers positions once their funds drop to 50% of required maintenance margin
  • All Brokers are to provide their customers Negative Balance Protection (NBP)
  • No more offering of Bonuses to current and potential customers to encourage trading.
  • Brokers to put up a risk warning telling customers the percentage of retail customers that lose money trading CFDs

But not all brokers have to follow these restrictions, and some brokers even encourage the use of excessive leverage.

As per this website, there are only a few FCA licensed forex brokers operating in the UK, but there are many international brokers which are not licensed by the FCA & ESMA regulators, but still actively accept traders from the UK & the EU.

Some of these brokers are not regulated in any Tier-1 regulation like the ASIC or similar regulatory body, and are mostly registered offshore. So, these brokers are able to offer high leverage to clients on derivative products such as CFDs, as a marketing strategy to attract more clients.

These brokers are not regulated in EU & the UK, but they still target & use marketing to attract retail traders in these regions.

To use higher leverage, some traders’ signup with these foreign unregulated brokerages, and this exposes them to third-party risks associated with these unregulated brokers who act as counter party against the traders, and also puts them at risk of losing all their capital to these brokers due to excessive risks.

The Mechanics of Leverage and Margin

Leverage is a potent tool traders have in their toolbox if you need to take more risk. However, experts are of the opinion that it is used ignorantly which leads to abuse.

As the saying goes “when the use of a thing is not known, abuse becomes inevitable”.

Let’s look at the mechanism behind leverage.

Leverage tells us the ratio between the amount of money a trader has and the amount of trade he can open. A leverage of 1:30 means for every $1, you can trade assets 30 times in size.

If you have $100 and your broker then offers you a 1:30 leverage, it increases your capital 30 times to $3,000 but if the leverage were higher at say 1:100, it increases your capital 100 times to $10,000.

There are different concepts of margin to take note of they are discussed below:

  • Account Equity is the total amount of money or stock you have in your margin account. It is your usable margin.
  • Initial margin is the amount of cash or stock you must deposit as collateral while your broker loans you the rest. It is always expressed as a percentage. Initial margin and leverage share an inverse relationship. If leverage is 1:30, initial margin is 1/30 or 3.33%
    The margin is required to be able to use leverage. Without margin, your broker or bank will not allow you access to leverage.
  • Usable margin is the amount of account equity left after taking out initial margin.
  • Margin level is the percentage of usable margin equity you are supposed to keep in your account at all times. It should always be above 100%.

Once your margin level drops to 100%, you cannot initiate new trades anymore and your broker will notify you immediately. Margin level is calculated with formula: Margin level = (equity/initial margin) x 100

When you lose a leveraged Trade

The more you trade, the more you keep drawing down your Equity usable margin. When your margin level falls to 100%, your broker places a margin call across to you.

A margin call is a situation where the money in your margin account is less than your potential loss.

This means that the money used as collateral cannot offset your loses. At this point, your broker requests you to make additional cash or stock deposits to your margin account failing which all your open positions will be closed.

Example

Assume you have a margin account with $10,000 equity in it. If GBP/USD currency pair is exchanging at $1.23 and you predict the exchange rate will rise you can buy CFDs to profit from that rise.

One CFD is always equivalent to one GBP/USD pair so a standard lot of 100,000 units will require 100,000 units of CFD

100,000 units of CFD should cost you $123,000 of your own cash. However, with a leverage of 1:30 and initial margin of 3.33%.

For the sake of easier calculation, let’s say that you will need to deposit just 3% of $123,000 or $3,690 while your broker lends you the balance.

Your usable margin equity reduces to $6,310 (i.e., $10,000 – $3,690)

Your margin level is now = ($10,000/$3,690) x 100 = 271%

Now if your prediction was wrong and GBP/USD exchange rate drops by 5% you lose $6,150 meaning you lost all the initial margin of $3,690 and will now deplete your equity by $2,460

Your new usable margin equity reduces to $3,850 (i.e., $6,310 – $2,460)

If you open another position, say for 100,000 units of CFDs of EUR/USD exchanging at $1.29 it should cost you $129,000 but with leverage of 1:30 you only need to deposit $3,870

New margin level is now = ($3,850/$3,870) x 100 = 99%

Now since your margin level is below 100% you will receive a notification from your broker to deposit more cash into your margin account so your margin level can climb above 100%.

FCA regulation related to the restrictions on CFDs sold to retail traders states under 1.15 that once your margin level falls to 50%, all the open trades will be closed.

This is considered important so that the CFD broker can prevent their losses result from client’s exposure & a trader doesn’t risk going into negative, especially during volatile market seasons.

Preventing a Margin Call

  • For stock traders, avoid illiquid & volatile stocks that will most likely shed its market value.
  • Avoid excessive leverage when trading both forex and stocks. The ideal leverage should not exceed 1:5 and 1:2 for both forex and stocks respectively.
  • Do not trade out of the fear of missing out (FOMO). Rather your trade should be meticulously planned and fastidiously executed.
  • Keep spare money for margin call requirements.
  • Use stop loss orders

Key Takeaway

In all activities in the financial market, trading or investing with leverage is a two-way street and it mostly results in huge losses.

If you are a retail trader, you should not be too greedy when applying leverage in your trade. Always watch the markets for volatility, and when you notice the markets are extremely volatile, then use leverage sparingly.

Don’t forget to use stop loss orders to manage your risks. Stop loss orders let you set a stop price such that once the underlying asset price crosses the stop price, your open positions are automatically closed and you cut your losses.

Lastly, before you trade with leverage make sure you understand the underlying asset and do your research. If you don’t understand it, don’t trade it.

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.