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Smart Use of Leverage

As we mentioned in a previous chapter, one of the biggest advantages for trading forex is leverage. With leverage, a little money can make a whole bunch if you are right, but leverage works two ways, and losses can mount in a hurry when you are wrong. In the forex market brokers will give you 100:1, 200:1 and even 500:1, and as tempting as it might be to dream about the big winnings from your highly leveraged trades, don’t do it. The surest way to have a quick unprofitable ending to your trading career is to use too much leverage.

It should be noted that Forex gives the trader the capability of using high leverage, and this can be dangerous only IF the trader does not know how to use it properly. 

Here are some facts about brokerage leverage:
  • The higher the leverage the higher the trader's buying /selling capability; 
  • The higher the leverage the lower the margin requirements
 Here is a table that illustrates brokerage leverage for $10,000 equity account size: 

Brokerage
Leverage
Buying/Selling Capability for
$10,000 equity
Margin % $ on hold for each $10,000 unit
20:1 $200,000 (2 standard lots, or 20 mini lots) 5% $500
50:1 $500,000 (5 standard lots, or 50 mini lots) 2% $200
100:1 $1,000,000 (10 standard lots, or 100 mini lots) 1% $100
200:1 $2,000,000 (20 standard lots, or 200 mini lots) 0.5% $50

A leverage ratio of 200:1 means that for every dollar the client puts up in collateral against potential losses, he can control $200. To control 1 mini lot worth $10,000, he needs to only put up $50. 
 
If a trader chooses a broker with higher leverage, it can be very beneficial to him providing he does not maximize the leverage capability granted by the broker. For instance, the benefit of a 200:1 broker is that the margin is a super-low 0.5%, which means that $50 must be put on hold for each $10,000 unit. So long as the trader does not abuse this privilege, he does not have to worry about a margin call.

Note: A trader cannot open a trading position that exceeds his available margin, and when the available margin reaches 0, he gets a margin call. 

While a trader can benefit from opening up an account at a broker with high leverage, it would be absolutely dangerous for him to use a significant part of that leverage for any given trade.

If a trader chooses a broker with high leverage, such as 200:1, it would be impossible for him to use the maximum available leverage because he would be too close to a margin call. It would also be foolish to use 1/4th of the available leverage, such as 50:1 leverage per trade. For instance, if he were trading 50 mini lots with his $10,000, he would be in a situation whereby every pip would equal $50. Since the forex market vacillates up and down by 100 pips, being on the wrong side of the market could cost him $5000 (100X$50=$5000), or 50% of his $10,000 account, in just one trade!

Let's see how many trades it would take to lose 25% of one's account under different leverage scenarios; proving one has a stop loss of 100 pips and $10,000 account: 

Trade
Leverage
Lot Size Loss Size per
100 pips
# of losses
to reach 25% DD
1:1 1 mini lot $-100.00 25
2:1 2 mini lots $-200.00 12.5
5:1 5 mini lots $-500.00 5
10:1 10 mini lots $-1000.00 2.5
20:1 20 mini lots $-2000.00 1.2
50:1 50 mini lots $-5000.00 0.5

As you can see from the above table, the ideal leverage to trade with is either 1:1 or 2:1, as this gives you the ability to afford 25 to 12 losing trades in a row and to still be in the game. Once you exceed 2:1 leverage, you are playing a dangerous game with leverage. The next one up, 5:1 leverage, only allows you to withstand 5 losing trades in a row before you hit 25% draw down, and five losing trades is very easy to accomplish. The other leverage scenarios are insane. The 10:1 leverage, 20:1 leverage and 50:1 leverage will all move your account to a 25% draw down in 2 or less losing trades. 

Professional Money Management: No more than 2:1 leverage per trade

Professional traders generally trade with 2:1 leverage, and you should consider this. Personally, I trade with no greater than 1:1 leverage. Through painful experience I have noticed that even the best of strategies can find themselves caught in whipsaw market lasting for an unexpected period of time that can cut them up (stop them out) on both sides of the market, resulting in an unexpected series of losing trades. I have learned to be on guard for such an event through lowering my leverage to zero leverage, or 1:1 leverage, in order to withstand the inevitable 25 trade losing streak. 

One must have the foresight to use minimal leverage, along with the discipline to keep stops in place at all times, in order to increase trader's longevity in this difficult market. Leverage can work for you if you know what you are doing, otherwise losses can accrue faster than on an unleveraged trading position. 

Conclusion

Most successful traders are careful, cautious, and objective when analyzing the market and seeking a trading opportunity. They rarely use more than 2:1 leverage, they always use reasonable stop losses and they use effective lot sizing models.

Novice traders, no matter how well schooled and prepared, often commence their career with a shaky start. They soon realize that not every trade makes money, and in fact most trades lose. Winning and losing trades often come in streaks, with more losing streaks than winning streaks. For a while everything works out, and then all trades turn sour. It is extremely important that you do not get too confident with a couple of winners, or get too despondent with a series of losing trades.

There are some common mistakes that the rookie trader makes. The biggest mistake is trading too big for the size of the account. If a move against you of 50 pips or less is going to cause you to liquidate your position or worse yet, the margin clerk does it for you, then you are trading too big. For new traders, it is generally better to trade a smaller unit size with a wider stop.

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