Forex leverage: How it works, why it's dangerous

Currency traders around the world are still reeling from the effects of the Swiss National Bank's surprise move to ditch its efforts at pegging the value of Swiss francs to euros.

For three years, the SNB had used its own war chest to make sure that a euro was worth 1.20 Swiss francs. After giving up on trying to artificially keep the euro strong and franc weak, the value of euros plummeted, thus wreaking havoc on global currency markets.

And it wasn't just large banks, hedge funds and corporations that felt the pain but also smaller traders and investors, as well.

Over the past decade or so, the world of foreign exchange trading has seen the emergence of brokerages that cater to retail, or smaller traders. While the accessibility to global currency markets had been reserved for just professionals, or larger institutions, retail forex brokerages allowed up-and-coming traders with limited financial resources to participate in the market.

However, the risks that kept the market "off limits" for the smaller folks came roaring back with a vengeance over the last couple of days.

Swiss franc Euro
Ulrich Baumgarten | Getty Images

The SNB's action to remove its currency peg pushed the value of euros relative to Swiss francs off a cliff, and allowed no real time for anyone to react, or manage trading risks in a traditional manner.

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The economic impact, in terms of losses, is much greater from a corporate or institutional standpoint. However, many retail traders found their trading accounts completely wiped out, being on the wrong side of a trade that couldn't be liquidated fast enough to preserve their capital. Trading in currency markets at the retail level, with these types of brokerages, centers on the use of one of the biggest double-edged swords in financial markets: leverage.

In other words, borrowed funds that are used to amplify potential returns but can also exacerbate the potential losses of trading positions. In the world of retail foreign exchange trading, use of leverage is key.

Here's how it works:

Let's say you want to take a $10,000 position in terms of Swiss francs. Under current regulatory guidelines in the U.S., you are mandated to keep at least $200 in your account in order to support that position. That's because there's a mandated minimum margin requirement of 2 percent for retail forex markets.

Read MoreEnding the Swiss peg: What it means

In other words, you can only have a position that's 50 times greater than the equity in your margin account.

If the value of your position grows because of market movements, there is no issue. But if your position loses value to a point where you no longer meet minimum margin requirements, your broker will liquidate assets to help assure that you don't lose more money than you put into the account.

The reason why some retail foreign exchange brokerages have gone bankrupt, and others are in severe distress, has to do with how those margin accounts were maintained during the SNB's shock move. Certain accounts with losing positions weren't able to be liquidated quickly enough before they went into deficit. That left some brokers responsible for the debit balances in client margin accounts. If those debit balances were high enough, that could cripple the capital position of these retail brokerages.

At that point, a handful of things can happen.

For one, the broker can request the client to add enough funds to bring their account back into good standing. Or, the broker is left holding the bag on client losses, perhaps with only legal recourse to try to recover those losses.

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According to Forex.com, which is a retail foreign exchange broker and is owned by publicly traded Gain Capital, the company does "reserve the right to hold clients responsible for large debit balances and in special circumstances." Its website also encourages clients to manage use of leverage carefully, since use of more leverage increases risk.

Bottom line, the pain of the SNB's removal of its currency peg hit numerous parts of the market, and will lead to outsized financial losses for the big guys and the little guys. On a relative basis, retail traders may feel more pain than their bigger counterparts.

The recent market action serves as a potent reminder of just how dangerous leverage can be when price action moves swiftly, and without warning.