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Leverage a Position while Day Trading in the Foreign Exchange Market

In the stock market, day traders can borrow up to three times the amount of cash and securities held in their accounts (although not all firms let you borrow the statutory maximum), and that amount is set by outside regulatory organizations. In the foreign exchange, or forex, market, there is no regulation on lending, and some forex firms allow traders to borrow up to 400 times the account balance.

The forex market is driven by leverage. Despite the nervous reports you may hear in the financial news, exchange rates tend to move slowly, by as little as a tenth or even a hundredth of a penny a day. And the markets are so huge that it’s easier to hedge risk.

You may have trouble borrowing shares of stock that you want to short, but you should have no trouble ever borrowing yen. To get a big return, forex traders almost always borrow huge amounts of money.

Forex firms allow such huge borrowing because they can hedge their risks so that, if you lose money, they make money. If you sell dollars to buy euros, for example, the firm can easily go in and sell euros to buy dollars. This capability makes its position net neutral. If the euro goes down relative to the dollar, you lose money, but the firm can offset its risk because its counter-trade went up.

The reason that a forex firm hedges its risks against its day trading customers is that most day traders lose money. The firm knows that, if it bets against the aggregate trades held by its customers, it’ll probably come out ahead. Don’t trade in forex or any other market until you’ve worked out a strategy and practiced it so that you can avoid becoming a statistic.

To illustrate how leverage in foreign exchange makes good returns possible, suppose the trader starts with a $1,000 account and borrows the maximum amount the forex firms allow, $400 for each dollar in the account.

All $401,000 are put to work buying euros. Note that the euro value stays constant, but the dollar value of those euros changes by hundredths of a penny. Thanks to leverage, the return is 11 percent — not bad for a day’s trading! Of course, you could lose 11 percent, which wouldn’t be so good.

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An exchange rate is just the price of money. If the dollar/euro rate is .7477, $1.00 will buy €0.7477.

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