Forex Trading Leverage - How Much is Too Much?

Leverage is one of the most important concepts to understand about Forex trading. It’s the reason traders are able to gain full exposure to a trade and experience big returns despite not having all the full amount of equity - something you’d need when trading something like traditional stocks or bonds.

Put another way, leverage makes trading more accessible by letting a trader trade more than they physically have. This happens in much the same way as someone purchases a house by borrowing from a bank; if you can deposit a percentage of the total value, the bank will cover the difference. When applied to trading it has you putting up a portion of the full trade amount with your broker covering the rest.

Before we delve too much further, let’s have a quick recap about how leverage works at a very basic level…

Let’s say you have $1,000 in your trading account (this is your equity) to put towards a trade. You could take that equity, apply a leverage ratio of 50:1 - this means for every $1 you put in, the broker will lend the other $49 - and thereby gain full exposure to a larger trade. In this case, your $1,000 combined with a 50:1 ratio (50 x $1,000) lets you control a $50,000 trade and the exposure to both the potential reward, and the risk, of the full amount.

Brokers will let you adjust your leverage up or down to suit your needs, as far as 400:1 in some cases which offers some big returns from a small outlay. That can be great in theory - especially so when it comes off - but there’s another side to leverage traders must always remember: leverage not only amplifies your profits, but your losses too. So the higher the leverage, the greater the risk.

To show the relative negative impact of leverage, let’s consider a scenario whereby two traders decide to put their $10,000 of capital behind the same trade but using different leverage sizes. Unfortunately for them, the trade goes against them to the tune of 100 Pips. 

 

Trader X

Trader Y

Trading capital (equity)

$10,000

$10,000

Leverage applied

50:1

5:1

Total trade Value

$50,000

$5,000

Result (Dollar value of the 100 Pip loss)

-$500

-$50

Loss as a percentage of the total equity

50%

5%

Percentage of equity remaining

50%

95%

 

As you can see, the results for each trader are significantly different, with the higher ratio of leverage greatly amplifying the loss of Trader X - in one trade, they have wiped out half of their equity. While Trader Y still experienced a loss, the more conservative approach to leverage means that, as a percentage, there was a lesser effect on their total equity.

The obvious conclusion from the above example is that if you want to mitigate risk it’s sensible to use less leverage. However, if the trades had gone the other way, in favour of the traders, Trader Y would have earned a greater profit, it would look like a great trade and they’d come out of it feeling pretty clever. This means the argument for low leverage isn’t necessarily straightforward.

Some traders actually prefer a higher degree of risk because of that potential for larger profits in a shorter time frame. The decision of how much leverage to apply is therefore very much a personal one, dependent on your trading style, general attitude to risk, availability of capital and what you want to gain from trading.

A tried and true method of figuring out whether you’re going too deep with your choice of leverage is to simply ask yourself what would happen if the trade went against you. How will it affect your bottom line? Could you afford to cover the loss? Simple questions like this should help guide you towards an answer. It also pays to remember that just because a broker is offering high leverage doesnt mean you have to take it. Leverage of 400:1 might be the maximum offered, but it’s not the level you have to trade at.

Ultimately, leverage is never something to be taken lightly. The more you use, the bigger the reward but the bigger the risk. So use your Demo account wisely, practice with virtual funds and get a real feel for the impact of leverage.

 

 

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