Using Leverage Safely
We return to this important topic of Leverage, so crucial in forex trading. We do so because most traders do not recognize the inherent danger of leverage. If you misuse leverage, your trading days are surely numbered. You'll most likely misuse it if you're overzealous and want to make a million a month!
First, let's make sure you really understand what leverage means.
Leverage enables small traders like us to trade large amounts of money by using the margin our brokers provide.
Some brokers offer 1% margin. This equates to a 1:100 leverage. This means you can control 100 times your deposit. For example, US$5,000 deposit entitles you to trade up to US$500,000. US$10,000 deposit entitles you to trade up to US$1,000,000. And so on .
This is maximum leverage. But what is really important is true (or real) leverage. That's what usually destroys small traders.
True Leverage = Total Value of Transactions / Total Trading Capital
Example: You have $10,000 in your account. You buy 100,000 EUR/USD. Your true leverage is: 100,000/10000 = 1:10
In other words, you will be trading with 10 times leverage on your account.
Another example: You have $10,000 in your account. You buy 200,000 EUR/USD. Your true leverage is: 200000/10000 = 1:20
In other words, your leverage on your account is 20 times.
Real leverage could enlarge your profits but also your losses. The greater your real leverage, the higher your risk.
Let's illustrate:
Two traders: A and B.
Both have $10,000 in their account. Their broker offers 1% margin. Therefore, A and B can trade up to a maximum of 100 times their deposit, i.e. $1,000,000.
Trader A is very aggressive. He buys 700,000 EUR/USD.
This is a real leverage of: 700,000/10000 = 1:70 (his leverage is 70 times!)
Trader B is more cautious. She buys just one lot of EUR/USD, i.e. 100,000.
Her leverage is: 100,000/10,000 = 1:10 (her leverage is 10 times)
They both bought at the same price of 1.1200, hoping to see the euro rise.
But instead of rising, EUR/USD drops by 100 pips, to 1.1100.
So, they both lose 100 pips!
Trader A, therefore, has made a loss of $7,000 ($70 per pip x 100 pips)
He loses 70% of his trading capital in one trade!
Trader B has made a loss of: $1,000 ($10 per pip x 100 pips).
She has lost 10% of her trading capital.
Let's see what this does to their trading account:
|
Trader A | Trader B |
| Trading Capital | $10,000 |
$10,000 |
| Real Leverage Used | 70 times |
10 times |
| Total Value of Transaction | $700,000 |
$100,000 |
| 100 pips loss | $7,000 |
$1,000 |
| % Loss of Trading Capital | 70% |
10% |
| % of Trading Capital left | 30% |
90% |
| Trading Capital Left | $3,000 |
$9,000 |
‘A’ has only $3,000 left on his account. He lost $7,000 in one day … because of high leverage.
‘B’ has $9,000 left.
Let’s imagine what happens the next day:
Both A and B believe they just had some bad luck. They are both anxious to recoup their losses.
Trader A has only $3,000 left in his account. Because his broker offers 1% margin, Trader A could only trade up to a maximum of $300,000 (3,000 x 100). But his broker’s platform will not allow him to trade the full 300,000. This is because just one pip move against him will bring his margin below 1% … and that’s not allowed. So, Trader A buys 200,000 EUR/USD. This is a real leverage of: (200,000/3000) = 1:66.6 (66.6 times!)
Trader B, being her cautious self, decides to buy just one lot – 100,000 EUR/USD. This is a leverage of 100000/9000 = 1:11 (11 times)
Terrible luck again! The trade begins to move against them. They both lose another 100 pips!
Let’s see what happens to their trading account.
| Trader A | Trader B | |
| Trading Capital | $3,000 | $9,000 |
| Real Leverage Used | 66.6 times | 11 times |
| Total Value of Transaction | $200,000 | $100,000 |
| 100 pips loss | $2,000 | $1,000 |
| % Cumulative Loss of Trading Capital | 90% | 20% |
| % of original Trading Capital left | 10% | 80% |
| Value of Trading Capital Left | $1,000 | $8,000 |
| % Margin left | 1% | 80% |
Trader A is now down to 1% margin on his account. This is the bare minimum. His broker will not allow him another trade. He will get a Margin Call, requiring him to deposit more money on his account.
Having lost $9,000 in two days, Trader A would most likely give up on trading altogether, and withdraw his $1,000. He’d join the ranks of the 95% of traders who lose in forex trading.
Trader B lives to fight another day. But some would argue that she’s still living dangerously … using too much leverage.
The more leverage you use, the greater your risk. A losing streak could easily wipe you out when you use too much leverage. All successful traders admit to having a losing streak. But they are able to survive because they use low leverage. Many professionals never risk more than 2% of their capital on any given trade.
And successful traders always ensure their accounts are properly capitalized. This means that they deposit sufficient funds on their account to enable them to trade comfortably. With sufficient funds, they can trade with proper leverage, ensuring that they survive the occasional losing streak. Low leverage with proper capitalization allows you to cope with small losses so that you can trade another day.
Most novice traders underestimate the potential devastation leverage can wreak on their accounts. Knowing when to use leverage and when NOT to use it is critical to your success. Don’t use leverage to destroy your trading capital … don’t take too lightly its destructive force.
If you want to give yourself the best chance to succeed, first learn to trade without leverage.
Play it safe. Protect your capital.
Don’t think that just because your broker lets you use high leverage with a low minimum deposit that you can make a quick buck or get rich quick. Approach the currency markets with respect.
Aiming to trade profitably is not about making millions by the end of this month or this year.
