So you think Forex leverage is cool huh?
Leverage is one of the most dangerous tools.
Many a beginner has blown his account trading leveraged.
But what is leverage?
And what separates those who use it wisely from those who don't?
Let's find out.
Since price moves in currency markets ain't that strong.
You need to hold a sizeable position to make (or lose) a good amount of cash.
For this reason, and to make FX trading more attractive to the average person, brokers allow a ton of leverage.
We're talking 50 to 1, and 200 to 1 in some cases.
Ok, but Emil, what are we even talking about? I don't understand a thing....
Leverage is the ability to trade with "borrowed" money.
For example, if you want to trade a mini lot (10,000 USD), you would normally need to have at least 10,000 USD in your trading account, right?
Not with leverage.
If you borrow 2 to 1, you can trade a $10,000 mini lot with only 5,000 in your account.
And if you leverage 100 to 1, you can trade the same amount with only 100 dollars.
Let's say you open an FX account with 1,000 dollars.
They allow you to leverage 100 to 1.
Which means you can trade a standard lot of 100,000.
You get into a trade, you're excessively lucky, and price moves 100 pips in your favor...
This means you just made 1,000 dollars.
But wait, your capital was only 1,000...
Yep, you just DOUBLED your capital in a snap.
And that's why many see trading as a way to quick riches, initially...
While going crazy with dreams of riches, people focus too much on what's to be gained.
But they don't think nearly enough about what's to be lost...
The same movement in the opposite direction would have WIPED OUT your account.
In the blink of an eye, bye, bye to your money.
So what? You say.
"I don't mind losing 50 or 100 bucks, if I can hit it big".
That's a load of bull. And I'll tell you why.
If you're new, you won't be profitable.
At least not consistently enough.
Since losing money sets you back more than gaining gets you ahead, you're doomed to fail.
Oh, you didn't know?
If you lose 10% of your account, you'll need to make more than 10% to get back to even.
Do the math exercise.
You don’t know what math to do?
Ok, here it goes:
You make 10% on a $1,000 account.
So you gained $100.
But if you lose 10% on a 1,000 account, you lost $100.
So let’s say you lost the 10%.
Now your account has $900, right?
To get back to even, you need to make $100.
But making 10% will only yield you $90.
Therefore, you will need to make more to get back to even.
And since leverage
amplifies this asymmetry, you will only screw yourself up.
This is especially important if you win close to 50% of your trades or less.
But as you progress into becoming consistently profitable (you win in 70%+ of your trades), this becomes much less worry-some.
Because the higher win rate counters the asymmetry of percentages.
If you win in 2 out of 3 trades, then it doesn’t matter that you need to gain more to get back even (after a loss).
This is provided all trades have the same size, and relatively similar risk (as signified from how wide is your stop).
It won’t hold if the trades you lose happen to be the ones you’re placing the most leverage (or total number of lots) on.
Or if those losing trades happen to be the ones with a very wide stop loss, while your winning trades have very tight take profit targets…
Use leverage only on those trades you know are very, very likely to go your way.
Like a Central Bank just shocking the markets with an unexpected rate hike. You know that currency is going to go up across the board.
So you can buy it with leverage and a decent stop loss, since its highly unlikely you’ll lose money on this trade.
But for anything much less clear-cut?
Use little to no leverage.
That’s one of the best way to ensure you’re not taking more risk than you can handle (the other is a sensible Stop Loss Order, which you should ALWAYS use).
Another negative effect of leverage is it messes with your mind.
Trading is already hard psychologically.
You’re afraid of losing your profits, so you take them prematurely, leaving many pips in the table.
Or you’re losing, and you can’t control yourself well, choosing to let the position open (when it’s clear your initial analysis/position was wrong), or worse, widening your stop loss.
These are all real issues Forex traders have to face. And Forex leverage amplifies them.
Suddenly, you’re not risking 2% of your account, your risking 10% or 20%.
Are you ok with that kind of risk?
For most people, that’s pushing it.
And so, limiting your use of leverage to the very best opportunities is the best way to limit these negative effects on your psyche (and your account balance).
And we got to the end of another interesting piece.
Remember that Forex leverage is only one of several strategies or “shields” in a sound Forex risk management policy.
Keep that in mind.
See you soon,
The Forex Economist
Sep 12, 17 09:09 AM
Learn what you need to know about Forex audio squawk here.
Sep 11, 17 09:48 AM
GBP (pound) traders what can you expect from the Bank of England's MPC vote this Thursday, Sep 2017? Click to find out.
Aug 21, 17 04:41 PM
Three of the eight major currencies are commodity currency. But what is that? Which are those currencies, and how can we trade them? Click to find out.