How to choose the right Forex leverage?
This lesson will cover the following
- What are the risks of high leverage
- How to offset leverage
- What is a common comfort level of leverage
Forex trading does offer high leverage in the sense that for an initial margin requirement, a trader can build up and control a huge amount of money, and high leverage means high risk. Leverage is a “double edged sword”. When you are right on your trade this leverage multiplies your gains. When you are wrong, however, same leverage exacerbates your losses. Far too many traders and investors fall to the temptation, which leverage brings about. Greed takes over when you lose the healthy respect for the market, which is something crucial for success.
Desperation to quickly win back losses that were created by excess leverage in the first place, can ultimately wipe out an account. When one gets complacent and makes that first wrong move the chances to spiral out of control are set in motion. It is crucial to stick to your plan, strategy and realistic goals. Leverage should be used with extreme caution.
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If the correct money management rules are applied, the amount of leverage can become irrelevant.
The reason for this? Traders base their risk on a percentage of their total account balance. In other words, the total amount risked per trade, even with leverage, is less than 2%.
A common mistake newbie traders make is to use inadequate leverage with no regard to the size of their account balance, which could be devastating. Without concern over the downside risk, high leverage can quickly wipe traders funds.
Lets say for example that a trader who has $2 000 in his live account decides to use a 100:1 leverage. This means that he would have a total amount of $200 000 dollars at his disposal, therefore he can trade two standard lots. As he buys those, each pip movement will earn or cost the trader $20. If we presume that he has placed his protective stop 10 pips away from his entry point, which is relatively tight, a potential triggering of the stop will cost him $200 – 10% of the entire trading account. This is far beyond what a balanced money management method would advise you to risk.
However, if the same trader instead uses a moderate leverage of 10:1, where each pip movement is worth ten times less, or in our case $2, he would end up losing only $20 – just a mere 1% of his trading account. This is a far more acceptable situation.
You should keep in mind that incorporating sound money management and only risking a certain small fraction of your money allows you to safely use leverage. According to those rules, the leveraged amount should be less than 2% of the trading capital, a percentage which most professional traders advise for the inexperienced ones to follow.
There is a relationship between leverage and its impact on your Forex trading account. The greater the amount of effective leverage used, the greater the swings (up and down) in your account equity. The smaller the amount of leverage used, the smaller the swings (up or down) in your account equity.
As tempting the ability to generate big profits without putting at stake too much of your hard-earned money may be, you should never forget that an excessively high degree of leverage could drain your entire starting capital in a blink of an eye. The following few safety precautions used by experienced traders may prove useful in diminishing the risks of leveraged Forex trading:
Use leverage adequate to your comfort level: If you are a cautious or an inexperienced investor or trader, use a lower level of leverage that you feel comfortable with, perhaps 5:1 or 10:1, instead of trying to mimic the professional players choice of 50:1, 100:1 and even higher.
Limit your losses: If you hope to achieve considerable profits somewhere in the future, you must first learn how to cut your losses in order to survive longer on the market and gather experience. Limit your losses to a manageable size to live to trade another day. That is achievable by following a sound money management system and using protective stops.
Use protective stops: Stops are of great significance because a single distraction that draws you away from your computer can result in losing hundreds or thousands of dollars when you miss a sudden price reversal. Since the Forex market is decentralized and remains open around the clock, some market players leave their positions open and go to bed, only to wake up the next day and see their account balance wiped. Going away from the computer without incorporating a stop loss is a suicide for your account. Moreover, stops are used not only to limit losses, but also to protect profits (trailing stops).
Don’t make the situation even worse: Dont attempt to turn around a losing position by adding more money and averaging down on it. It defies logic to stick to a losing position and risk more and more of your trading capital, hoping for a miracle turnaround. Eventually that losing position will become so large, that your account wont be able to contain it and you will be forced to exit the position at a huge loss which exceeds many times what you would have lost in the first time.
Even if the price action does eventually reverse at some point and you think you should have stuck to it, relax. Such decisions, based solely on emotions and not on solid technical/fundamental analysis are one-time winners and will render you a losing trader in the long-term. Its much better to exit the position, score a minor loss and offset that loss by entering some other, winning position, instead of wasting your time and money on losers.