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 for leverage?
Forex trading offers high leverage in the sense that, for an initial margin requirement, a trader can control a huge amount of money; however, high leverage also means high risk. Leverage is a “double-edged sword”. When you are right on a trade, this leverage multiplies your gains. When you are wrong, however, the same leverage exacerbates your losses. Far too many traders and investors fall prey to the temptation that leverage brings. Greed takes over when you lose a healthy respect for the market, and that respect is crucial to success.
The desperation to quickly win back losses created by excessive leverage in the first place can ultimately wipe out an account. When a trader becomes complacent and makes that first wrong move, the chances of spiralling 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.
If the correct money-management rules are applied, the amount of leverage can become irrelevant.
The reason is that 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%.
Example
A common mistake new traders make is to use inappropriate leverage with no regard to the size of their account balance, which can be devastating. Without concern for downside risk, high leverage can quickly wipe out traders’ funds.
Let’s say, for example, that a trader who has $2,000 in his live account decides to use leverage of 100:1. This means he would have a total of $200,000 at his disposal and could therefore trade two standard lots. As he buys those, each pip movement will earn or cost the trader $20. Assuming that he has placed his protective stop 10 pips away from his entry point, which is relatively tight, triggering the stop would cost him $200 – 10% of the entire trading account. This is far beyond what a balanced money-management method would recommend you risk.
However, if the same trader instead uses moderate leverage of 1:10, where each pip movement is worth one tenth as much – in our case $2 – he would end up losing only $20, just 1% of his trading account. This is a far more acceptable situation.
You should keep in mind that incorporating sound money management and risking only a small fraction of your capital allows you to use leverage safely. According to these rules, the amount at risk should be less than 2% of your trading capital – a percentage most professional traders advise inexperienced traders to follow.
- Trade Forex
- Trade Crypto
- Trade Stocks
- Regulation: NFA
- Leverage: Day Margin
- Min Deposit: $100
Useful advice
There is a direct 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.
Tempting as the ability to generate large profits without risking 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 the blink of an eye. The following 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 inexperienced investor or trader, use a lower level of leverage with which you feel comfortable – perhaps 1:5 or 1:10 – instead of trying to mimic the professional players’ choice of 1:50, 1:100 or even higher.
Limit your losses: If you hope to achieve considerable profits in the future, you must first learn how to cut your losses in order to survive longer in the market and gather experience. Limit your losses to a manageable size so you live to trade another day. This 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 if you miss a sudden price reversal. Since the Forex market is decentralised 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 that their account balance has been wiped out. Going away from the computer without incorporating a stop-loss order is financial 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: Don’t 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 won’t be able to contain it, and you will be forced to exit at a huge loss that exceeds many times what you would have lost in the first place.
Even if the price action eventually reverses and you think you should have stuck with it, relax. Decisions based solely on emotions and not on solid technical or fundamental analysis are one-time winners and will render you a losing trader in the long term. It’s much better to exit the position, take a minor loss and offset that loss by entering another, winning position, instead of wasting your time and money on losers.