Over the past couple of years, the Forex market and CFD market have enjoyed continued and growing interest from Forex traders and investors. Forex traders appreciated, above all, opportunities offered by this market – investing regardless of the prevailing market trends thanks to both long and short positions, low transaction costs, and something that – until recently – seemed to be an inherent feature of the Forex market and CFDs – high Forex leverage.
The regulations of the European Securities and Markets Authority (ESMA), which are in force since 1 August 2018, set the maximum leverage level in Forex at 1:30 and for other asset classes at even lower levels – 1:20 for CFDs on indices and at 1:2 for Contracts for Differences on cryptocurrencies. Many traders have asked themselves a question, whether implementation of ESMA’s regulations is the end of the Forex market we have known for years and have accustomed to? Others have already raised another issue – is there a chance to continue trading Forex and CFDs with 1:100 or even 1:500 Forex leverage?
What are CFDs?
A Contract for Difference (CFD) is an agreement between two parties – the issuer and the buyer of the contract – obliging the parties to settle in cash the difference between the opening price and the closing price of such a contract. CFDs are classified as derivatives, which means that the contract price depends on the price of the instrument – the so-called underlying instrument – to which the contract is issued. For example, the value of an oil CFD depends on the current market price of oil. A CFD contract on an EURUSD currency pair depends on the current exchange rate of the Euro against the United States Dollar. What is important, a CFD contract is only a speculative instrument – you do not become the owner of the asset on which you make a transaction – you only settle any difference between the opening price and the closing price of the CFD contract.
CFDs – as derivatives – offer the possibility to take advantage of the increase, as well as the decrease of price of the underlying asset. If an investor expects the price of a given asset to rise, e.g. gold, he can buy a CFD contract for gold – it is said that the investor has a long position in gold or even more colloquially – he is long in gold. Since CFDs are assumed to settle only the difference between the opening and closing price of a contract, this means that if the investor has anticipated the market development well – the price will go up – the closing price will be higher than the opening price and the investor will make a profit. If the opposite had happened, i.e. the price of gold would have fallen and the investor would have had a long gold position – he would have bought a CFD gold contract – the closing price would have been lower than the opening price and the investor would have recorded a loss.
Contracts for Difference also allow traders to position themselves in anticipation of a decrease in the price of the underlying instruments. If you expect the price of an asset to fall, e.g. the German DAX index, you can sell the CFD on the DAX – you are said to have a short position on the contract or you are short on the DAX. If the investor’s expectations are correct and the price of the CFD contract on DAX decreases, the investor will make a profit – the closing price of the contract will be lower than the price of its opening. If the opposite situation had occurred, i.e. the index price had risen, the investor would have recorded a loss – the closing price would have been higher than the opening price.
What is leverage on Forex and CFD?
An inseparable feature of Contracts for Difference CFDs, as derivatives, is financial leverage, i.e. the so-called Forex leverage. CFDs are financial instruments based on margin trading. This means that an investor trading on CFDs does not have to contribute the full amount of the nominal value of the contract.
For example, if you trade with a leverage of 1:10, you will need to have and maintain a margin of only 10% of the contract value in order to open a position. If a CFD is worth 100,000 EUR, the investor will only need to have 10,000 EUR in his Forex trading account. The situation will be similar when the leverage is 1:100 – then the trader will be required to maintain only 1% of the margin for the transaction. For the example mentioned above, to trade 100,000 EUR contract it is sufficient for an investor to have only 1000 EUR in his Forex trading account.
What does high leverage Forex trading mean in practice? Since the market position can exceed one hundred (1:100 Forex leverage) or even five hundred (1:500 Forex leverage) times own trader’s funds on trading account, both potential profits and losses will be multiplied in line with the leverage levels.
Going back to the previous example, trading Forex with a leverage of 1:100, an investor with only 1000 EUR on his account can trade positions exceeding his own capital 100 times, e.g. a position of 1 lot on an EURUSD currency pair equal to 100,000 EUR. Having such a large market exposure with a small deposit on a brokerage account leads to a situation where even a small price change or increased volatility causes significant changes in the investor’s trading account. In the example above, a change in the EURUSD exchange rate from 1,500 to 1,1600, or just 100 pips, will result in – depending on the position (short/long) and the direction in which the price changes (up/down) – a gain or loss of $1,000. This means that in a short time investor can practically double his account or wipe out his account – lose all his invested funds. Therefore, Forex leverage must be used with extreme caution, paying the utmost attention to money and risk management mechanisms.
What Forex leverage should I trade Forex with?
ESMA’s regulations, implemented on the 1st of August 2018 which introduced Forex leverage limits for Forex brokers registered in the EU, were aimed at ensuring a higher overall level of protection for retail clients. Will the introduction of a leverage limit on Forex at 1:30 better protect interests of Forex retail clients? Will traders stop losing money in Forex just by lowering their maximum available leverage? Big question marks appear here. Why? Because in the majority of cases, Forex traders losses are caused by them trading too big positions and holding uncontrolled market exposures. Let us look at the two examples below.
The Forex trader has 5,000 EUR on his trading account and trades Forex with a leverage of 1:100. This means that his market positions are opened with a margin requirement of only 1%. The investment strategy applied by the investor assumes that he trades Forex with a volume equal to 0.1 lot in each transaction. A second investor trades with the same amount of capital equal to 5,000 EUR but invests with a leverage of 1:30. Lower Forex leverage means that he needs 3.33% of his own capital to open and maintain market positions. This trader does not use professional money and risk management mechanisms, and his market positions often reach volumes of 0.3, 0.5 or even 1 lot. Which of these traders invests in a more risky way? Although the first investor trades Forex with higher leverage, he does not fully use it as he trades the fixed value of 0.1 lot per transaction. The second investor, despite lower leverage on his account, take a higher risk because trades higher volumes in each transaction. The impact of 1.0 lot transactions on the investor’s account is ten times greater than the impact of 0.1 lot transactions, regardless of the leverage used on the account.
So what Forex leverage level should be chosen when trading Forex? This decision should be made by each Forex trader individually. A high level of leverage – even though it does not carry any additional risk in itself – may in a way tempt the investor to take full advantage of the leverage and strive to trade positions for the whole of his equity. If an investor is not capable of managing money and risk properly and, most importantly, makes emotional decisions, a higher level of Forex leverage on his account will not be suitable for him. Experienced traders can work on high Forex leverage – professionals who control their emotions and their investment process are well thought out and consistently executed.
Which broker offers a Forex leverage higher than 1:30?
If you understand the leverage and are able to use it to maximize your return on investment, probably you are looking for a broker who will provide you with a leverage level higher than the maximum in the European Union, i.e. 1:30. There are many Forex brokers and CFDs providers on the market, brokers who are often registered in extremely exotic locations such as Belize and the British Virgin Islands. These are certainly great places to visit for tourists, but will it be the desired place and, above all, a safe place for your money? Offshore brokers are not regulated by any respected financial services authority, and therefore you have no certainty that they are operating in accordance with the law. Moreover, they do not offer any funds guarantees in case of bankruptcy of the broker. Therefore, we advise to trade only with brokers from reputable jurisdictions under the supervision of a sound financial services regulator.
One of such brokers is definitely Dukascopy Bank, a Swiss-based broker supervised by the Swiss Financial Market Supervisory Authority (FINMA). As Forex brokers in Switzerland require a banking license, Dukascopy Bank’s customer deposits are perfectly protected and guaranteed by the Swiss compensation scheme up to 100,000 CHF. Moreover, Switzerland is not part of the European Union and is therefore not obliged to apply the ESMA leverage regulations. This means that Dukascopy Bank’s clients can trade Forex market with a maximum leverage of 1:200. If we add to this a wide range of products, including CFDs on Forex, indices or commodities, low spreads and commissions, as well as intuitive MetaTrader and JForex trading platforms, we receive a reliable partner for our investments. Dukascopy Bank offers a free demo, which will allow you to try out broker’s trading platforms and trading conditions.
The Australian broker IC Markets is the second broker worth taking into account when planning to trade Forex market with a high leverage of 1:500. IC Markets is regulated and licensed to conduct investment activities by the Australian Securities and Investments Commission (ASIC). ASIC guarantees brokers’ compliance with the law and local regulations, so you can be confident that IC Markets is a reliable investment partner. Clients’ trust in IC Markets can be proven by the broker’s trading volumes, which in May 2018 reached its highest value in history amounting to 447 billion dollars. IC Markets offers Forex leverage up to 1:500, spreads from as low as t 0.0 pips and extremely low commission rates. MetaTrader 4 and cTrader trading platforms offered by IC Markets are well known and valued on the market for their functionality, ease of use and openness to algo and Expert Advisor solutions. Free demo at IC Markets perfectly shows how solid the broker is.