Well it was a big three days. Last week I went on a seminar to learn about how to trade foreign exchange, e-minis, futures and commodities.
And more importantly – how to analyse a few factors in the world and decide where things like currencies and commodities will go over the medium to long term.
The seminar itself was great. The content was good, I am all ready to go and trade but I wonder…
What happens if I blow my money up ? -What happens if I lose 400% in 4 weeks?
That’s ridiculous you say – how could anyone lose 400% in 4 weeks. Well – because of MASSIVE leverage (see more below) on foreign exchange.
Foreign Exchange is when you buy one currency and sell another.
For example: I go to USA and I draw out $1,000USD from the ATM. So the bank has transferred my Australian dollars into USA Dollars.
So if someone says they have BOUGHT USA dollars (obviously they have also SOLD something else like Australian dollars).
Obviously without having both currencies there is no foreign exchange – If I earn Australian dollars and spend Australian dollars – there is no foreign exchange.
If I buy $1,000 USD today – it would cost be about $1,000 AUD.
But in 2008 – the exchange rate was 0.93c then down to 0.68 cents and back up again.
(the 0.93c refers to how much $1AUD buys).
USD $1,000 would have cost approx $1,600
A few good things about currencies is that they are reasonably predictable and also won’t go to zero.
You might buy a share in a company that becomes worthless (think ABC Learning Centres, HIH, etc etc.). But the value of a countries currency will never go to zero (although I wouldn’t be buying Zimbabwe dollars any time soon).
Leverage allows you to control something larger with a smaller amount (like a lever!).
Leverage has been called a double edged sword. Really it is like a magnifier or multiplier.
It means you can make massive profits but also massive losses.
Leverage and Property
Property is a great example of leverage. Say you buy a $500,000 house with 20% deposit ($100,000).
Your 20% (being the $100,000) allows you to control something worth 5 x as much (or 5 x leverage).
5 x leverage is because 20% as a fraction is 1/5th.
If you only had a 10% deposit ($50,000) – you would be controlling the property with 10 x leverage.
Effect of Leverage
Lets say the property goes down 5% – from $500,000 to $475,000.
Whether you paid 20% or 10% deposit, you have still lost the same dollar amount $25,000.
However – with 20% you invested $100,000 and lost $25,000 = 25% loss on deposit.
With 10% you invested $50,000 and lost $25,000 = 50% loss on deposit! (or lost ½ your money)
The leverage makes a huge difference – in the above example the percentage loss doubled because of half the deposit. (So you can probably see why banks make you buy mortgage insurance for a property if you have a lower deposit to protect themselves if you default).
But when you make profits – leverage increases or magnifies your returns. When property has doubled in value over 10 years – your rate of return on your deposit would be huge!!
Also why it is good to use leverage to buy property is because as long as you make the loan repayments, the bank won’t ask you to repay the loan if the property decreases in value by 5%. You can just hang onto the property (and hopefully things will turn around in time).
Foreign Exchange Leverage
Ok –so back to Foreign exchange.
Foreign exchange allows MASSIVE leverage.
The margin on foreign exchange is either 2%, 1% or 0.5% (through the brokers I’m using).
This means either 50x, 100x or 200x leverage!
So if you buy $100,000 of USD (say USD/AUD as you need another currency to transfer) – your margin would either be $2,000, $1,000 or $500!!!!
So the danger is using the 0.5% margin and saying – well I have only put $500 on the trade. But because of 200x leverage you are controlling $100,000.
Losing 400% in 4 weeks (or making it if you are lucky!)
If the price moves 1% you make (OR LOSE) $1,000. While this means you could make an absolute KILLING if you got it right…. You could be ABSOLUTELY SMASHED if you get it wrong!
So if you have 2% margin $2,000 and goes down 2% – lose $2,000 (100%)
If you have 1% margin $1,000 and goes down 2% – lose $2,000 (200%)
If you have 0.5% margin $500 and goes down 2% – lose $2,000 (400%!)
Obviously there are many strategies we were taught in the seminar to deal with this leverage.
But generally – you trade only a very small portion of your account and leave the rest in cash (just in case it goes down).
So if you paid $500 to control $100,000 – you would leave $5,000 cash (at least – maybe more like $10,000) in the account to cover negative movements.
Another thing the course covered was your mentality.
Trading shares requires a mental toughness, and learning things that seem counter-intuitive.
And you have to be willing to lose money. Full stop. Nobody makes money all the time. Everybody loses money and realising that you will lose money investing and trading means you can concentrate on not losing too much money.
Well after that, I suppose all I can say is… wish me luck!