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AB10 - How Leverage Affects Transaction Costs

"Leverage is probably one of the least understood things in forex. For many traders, leverage is all about increasing their exposure to the market. This means having to trade on borrowed money or trading on margin. While the potential to make larger profits are the common goal, there are also other aspects that traders need to consider. For example, did you know that the larger contracts you trade, higher the costs of transactions involved? This is because of using leverage. There is a fine balance between using leverage and maintaining the margin on your trading account. Traders need to account for these factors as well and not just focus on the profits that one can make. In this article we give you the lowdown on how leverage can affect the cost of transactions. This in turn will affect the margin account that you are required to keep in order to use leverage."

So far, we covered the basics of what leverage is and the meaning of trading on margin. While we know that leverage allows you to control larger positions in the market, there is also an unintended effect.

The transaction costs that you pay can also greatly increase. This is but the logical conclusion. The bigger contract sizes that you trade, higher the costs associated with that transaction.

Not many traders pay attention to this, but the cost of transactions are not leveraged. Therefore, while on one hand you can trade larger lots, the costs for each of these transactions are also high.

Perhaps the best way to explain how leverage affects your transaction costs is by means of an example.

Assuming that you trade with a fixed broker, you are charged a fixed spread of 2 pips on the EURUSD currency pair. Let’s say you initially deposited $1000 and you opted for a 1:100 leverage. This means that you can now control up to 1000 x 100 = 1,000,000 units. This is nothing 10 standard lots.

But because of the fact that you have to maintain a margin, you obviously won’t go for the maximum lots that you can trade. So, let’s assume that you purchase one mini lot. As you might already know, one mini lot is equal to 10,000 units.

Therefore, the pip value here becomes $1. Since your fixed spread broker charges you a spread of 2 pips, that means you end up paying $2 on the transaction. Notice that while you were able to trade higher lots, the transaction costs also increase.

Scaling this very same example, now let’s say you traded one standard lot. One standard lot is equal to 100,000 units. In this case, the pip value now becomes $10. With a fixed spread of 2 pips, your transaction costs have increase to $20.

The spread is what you pay to your forex broker. Thus, when deducting from your actual capital, you are either $2 or $20 down depending on the lot sizes that you traded.

Taking this same example, we can also see that transaction costs increase when you trade with an ECN or an STP broker too. Such brokers charge you just a flat commission. Let’s say that the broker charges a commission of $5 per round trip lot.

This means that you pay $2.5 when you open the trade and pay $2.5 when you close the trade. Given that these are the costs for a standard lot, 100,000 units you can see that you have to pay $5 if you trade one standard lot.

If you were to trade a smaller lot size, such as mini-lot, then your costs would of course become $0.25 one way, or $0.50 per trade, round trip.

While leverage is something that many traders cannot live without, you should pay attention to the fact that they can also increase the cost of transactions.

Another factor to pay attention to is the overnight swaps. For example, if you were to keep your trade open overnight, then you will be either credited or debited with the overnight cost of financing the two currencies.

The overnight transaction costs are also dependent on the size of the contract that you trade. Therefore, the higher the volumes, the higher the overnight cost of financing is. Remember that while you are charged all the above fees, these costs cannot be leveraged.

The charges come directly out from your trade or from your account capital. Combining the above charges and the fact that you will also have to monitor your trade, you can see how easily it can get very risky.

By merely using leverage, on one hand you are able to control larger volumes or contract sizes. On the other hand, your costs for these transactions also grow by the same factor. This can eat into your account capital and can eventually effect the margin as well.

When your account falls below the minimum margin requirements, you are obviously margin called and you need to deposit additional funds in order not to have your positions liquidated.

In conclusion, leverage and margin are commonly used in forex trading. Traders mostly tend to focus on the profits that leverage can bring. But on the other hand, not many traders focus on the other aspects such as the trading or the transaction costs.

It is essential that traders are able to maintain a balance between the leverage they use the margin requirements while at the same time accounting for the costs of the transactions as well.

Read 915 times Last modified on Saturday, 15 June 2019 11:43