Leverage: The Double-Edged Sword
Most traders gravitate to Forex because of leverage; the power to control a trading position that is much larger then your available funds. Leverage is the vehicle which allows the ordinary independent, non-bank trader to participate in the Forex market.
Using high leverage has the potential to increase your gains, but notably it has the capacity to amplify your losses. The key is to understand the link between how much you are willing to trade (trade size) at any given time, and your account capital or equity. Then you can set your leverage accordingly.
Many Forex traders think that just because their account is set with a certain amount of leverage, that they are trading that much leverage with every trade. But that is not the case and should not be the case, because most Forex brokers offer a much higher level of leverage than what is reasonable to use.
Don’t Do This
For instance, some Forex brokers allow leverage as high as 400:1. This really only benefits Forex traders with account capital as low as $50. With a $50 account, they can participate in Forex by trading a huge amount using very little money. If a trader opens an account of $50 and uses the 400:1 leverage to the full it would mean trading a 20K lot size (0.2 or $2 a pip) and a 25 pip loss would completely wipe out that account!
What Your Lot Size Means In Terms Of Leverage
Forex lots are traded in terms of 100K. So if your account is based in USD, which for sake of simplicity is the base currency of all the examples mentioned in this article, then a 100K lot is usually referred to as a lot size of 1. The value of this lot size is that every pip that a trade moves is worth $10. In other words:
100K lot = lot size of 1 = $10 a pip
50K lot = lot size of 0.5 = $5 a pip
10K lot = lot size of 0.1 = $1 a pip
5K lot = lot size of 0.05 = $0.50 a pip
1K lot = lot size of 0.01 = $0.10 a pip
Learn How To Calculate Leverage
To understand this, first, let’s learn how to calculate the leverage you are using with each trade by using two inputs; trade size and equity.
To calculate leverage, all you do is divide your trade size (position size) by your account balance (equity).
For example, suppose you have an account with a balance, or equity, of $10,000. A 10:1 leverage would mean that you are opening positions no larger than $100,000 at a time, or a 100K lot.
So applying that simple formula:
Trade size ($100,000) divided by account balance ($10,000) = 10:1.
Being a conservative trader, I think trading with 10:1 leverage is still much too risky. In this scenario of a $10,000 account; a 100 pip loss would be $1000; and that is much too high risk. While the gain potential is attractive, I would not recommend a lot size this large; the losses at stake are way too steep.
Instead, a conservative amount to trade would be a lot size of 0.2 – which is a $20,000 lot or referred to as a 20K lot, or $2 a pip.
Trade size ($20,000) divided by account balance ($10,000) = 2:1 leverage.
Using this leverage, a 100 pip loss would be just $200
Game plan: Keep Your Total Leverage Amount Low.
Keep in mind that if you are trading multiple trades at a time, then you should use a lower amount of leverage. For example, lets say you decide to trade with 4:1 leverage in your $10,000 account, so you open a trade with a 40K lot.
Well that is reasonable if you are just trading one trade; you are not risking too much. But what if you are trading five positions of 40K lot trades then you are actually trading a total lot size of lot size of 200K. That means your leverage for all positions is 20:1 and you are terribly over-leveraged on these trades. So knowing that you will be trading multiple positions, you should lower your lot size accordingly and trade each position with overall smaller lots.
Bottom line: Look at the total number of trade positions in your account and never let the leveraged amount exceed 10 times your equity.