This article was written by Adinah Brown from Leverate.
New traders often ask if it is possible to go into debt - can you lose more money than you put in? It might seem like a silly question, but actually, the way that Leverage works means that it is eminently possible.
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Let’s explain using something that is very common, a housing loan and the housing market. If you buy a house for 1 million dollars and borrow 80%, you have personally provided $200K and the bank has put in $800K. Now, let’s say that the market takes a downturn, like Florida did in 2010. Now your million-dollar property is worth a little bit lower, let’s say, it’s now worth $750K.
The math behind this is simple enough, though is quite problematic - you owe $800K on a property worth $750k. That’s not good, but that’s not all either. You started with $200K of your own money, and not only is it gone, but an extra $50k has disappeared.
If you sold the house for market value of $750k, you would actually still owe the bank $50k after giving them all the money that you made from the sale! Back in the global financial crisis when US housing prices took a severe dive in many markets, this was actually happening, albeit with a twist.
Instead of selling the house and owing the bank more money, people were just handing the keys to the bank and walking away. Using the example above, a person who just gave the house to the bank and walked away would only have lost their initial investment of $200K. And the bank would have lost 50K, because it could only sell the house for $750K but they put in $800K. Because they put in the money and couldn’t get it out of the person who borrowed it, they made the loss.
Margin Calls
So far we have spoken about houses, but it is the same in leveraged trading. To protect themselves from this, brokers have instituted an element called a margin call. At a simple level it cuts off positions automatically when they become worth less than the original investment, so that the person trading can’t lose the borrowed money as well.
But not every brokerage structures it this way. Let’s say that it has a different structure, one that forces the trader to pay for the losses beyond the original investment. Conceivably, this means that the trader will have to make up the total amount of losses greater than the initial outlay. To use our house example, the trader would have to pay the extra $50K to the bank.
However, the house utilized a leverage of 80:20, meaning that the bank lent $80 for every $20. At many brokerages, the leverage can be in excess of 100:1 or more.
France steps in to protect clients
Because of this leverage amount, things can go south very quickly. This very situation was occurring in brokerages that were operating in France. As a result, in January of 2017, the French regulator (AMF) instituted a change to its monetary and financial code, which was aimed directly at the brokers that allowed traders to trade beyond their initial outlay without a margin call apparatus in place to protect traders from going below zero. The specific areas identified in relation to CFDs that were banned were:
- When the maximum risk is unknown by the trader
- When the risk of loss is greater than the amount initially invested
- When the risk of loss compared to the potential advantages is not reasonably understood
It is easy to fathom how confusion about leverage, margin call structure or loss risk can be a particular challenge to newer traders. Account managers in brokerages will describe how often traders struggle with these basic elements, and indicate how beneficial the measures are in protecting new, inexperienced traders.
The French regulators took a strong step in the right direction to create a system that protects the most vulnerable without limiting the ability to trade, and are to be commended for the strong insightful action. It will be interesting to see if other jurisdictions in Europe follow suit.
