To put it simply, leverage means using a small amount to control a bigger amount of – in the case of forex trading – money. A lot of forex brokers allow their clients to use leverage on their trading activities. The question, however, is how much leverage is appropriate to use for a particular trade.
The Right Leverage Ratio
Leverage and how it impacts your trading account should be considered when using leverage. The bigger the effective leverage applied, the bigger the up or down swings in your account equity can be expected. With a smaller equity, on the other hand, there will be smaller account equity swings. In general, no more than 10x leverage use would be recommended.
Your broker may allow you to use a high amount of leverage, but it doesn’t mean that you have to apply it all in your trading. Think of your leverage as a car. Just because it can run up to a speed of 240 mph, it does not necessarily mean that you have to drive that fast all the time. For one, you are more likely to figure in a road mishap the faster you drive. It is the same way in forex trading, the higher the leverage amount, the greater the risk you are exposing your account to.
Why Using a Lower Leverage Amount Is Encouraged
If you use your leverage excessively, a lot of your winning trading positions may be nullified by just a few losing positions. This is because you can potentially lose a lot of money from high leverage use. Depending on your leverage limit, one loss could even wipe you out.
To illustrate how this can be possible, consider the following example:
Trader X buys 50 lots of EUR/USD, while Trader Y buys 5 lots of the same currency pair. Now, what will happen to both traders’ account equity if the pair drops by 100 pips? The answer: Trader X loses 50% or half of his account equity, while Trader Y loses just 5% of his. This is shown on the table below:
|TRADER X||TRADER Y|
|Trading Account Equity||$10,000||$10,000|
|Trade Size (notional)||$500,000 (Buys 50 x 10K lots)||$50,000 (Buys 5 x 10K lots)|
|Leverage Applied||50:1 (50x)||5:1 (5x)|
|100 Pip Loss||-5,000||-500|
|% Equity Lost||50.0%||5.0%|
|% of Remaining Equity||50.0%||95.0%|
Because of his lower leverage use, Trader Y was able to minimize the devastating effect of losing 100 pips. This is why it usually pays to be conservative by limiting your leverage to under 10%. This will, however, still depend on your risk appetite. You can go for 10:1 leverage if you are an aggressive trader. More conservative traders, on the other hand, usually settle for 3:1 leverage – sometimes even less.