As a trader, you must grasp both the advantages and disadvantages of trading with leverage.
Using a 100:1 ratio as an example, it is feasible to enter into a deal for up to $100 for every $1 in your account.
You can trade up to $100,000 at 100:1 leverage with as little as $1,000 of margin in your account.
This allows you to profit on the equivalent of a $100,000 trade!
When leverage works, it greatly magnifies your gains. Your mind expands and you believe you are the greatest trader who ever lived.
However, leverage can be used against you.
Leverage will AMPLIFY your potential losses if your trade moves in the opposite way.
Here’s a graph that shows how much your account balance changes based on how much leverage you have.
|LEVERAGE||% CHANGE IN CURRENCY PAIR||% CHANGE IN ACCOUNT|
Assume you purchased USD/JPY, which rises by 1% from 120.00 to 121.20.
Here is how leverage would affect your return if you traded one typical 100k lot:
|LEVERAGE||MARGIN REQUIRED||% CHANGE IN ACCOUNT|
Assume you purchased USD/JPY, which falls by 1% from 120.00 to 118.80.
Here is how leverage would effect your return (or loss) if you traded one ordinary 100k lot:
|LEVERAGE||MARGIN REQUIRED||% CHANGE IN ACCOUNT|
You start a $500 mini account that trades 10,000 mini lots and only requires a.5% margin.
You purchase two small lots of EUR/USD.
The genuine leverage for you is 40:1 ($20,000 / $500).
You set a stop loss of 30 pip, and it is activated. Your loss is $60 ($1/pip multiplied by two lots).
You have just lost 12% of your account ($60 / $500).
Your account balance has increased to $440.
You think you’ve merely had a lousy day. You’re feeling good the next day and want to make up for yesterday’s losses, so you decide to double up and buy four mini lots of EUR/USD.
The true leverage is approximately 90:1 ($40,000 / $440).
You set your standard 30-pip stop loss and trade losses.
Your loss is $120 ($1/pip multiplied by 4 lots).
You’ve just lost 27% of your account ($120 loss on a $440 balance).
Your account balance has increased to $320.
You trade again because you feel the tide will turn.
You purchase two small lots of EUR/USD. Your true leverage is approximately 63:1.
You set your standard 30 pip stop loss and lose once again! Your loss is $60 ($1/pip multiplied by two lots).
You’ve just lost about 19% of your account ($60 loss / $320 balance). Your account balance has increased to $260.
You’re becoming irritated. You try to consider what you’re doing incorrectly. You believe your stops are too tight.
The following day, you purchase three micro lots of EUR/USD.
The true leverage for you is 115:1 ($30,000 / $260).
You increase the size of your stop loss to 50 pips. The transaction begins to go against you, and it appears like you are about to be stopped out once more!
But what follows is even worse!
You’ve received a margin call!
Because you opened three lots with a $260 account, your Used Margin was $150, resulting in a meager $110 Usable Margin.
The deal went against you by 37 pips, and you received a margin call because you had three lots open. Your stake has been settled at market value.
The only money left in your account is $150, which was returned to you following the margin call.
After four trades, your trading account has decreased from $500 to $150.
A 70% loss!
Congratulations, you won’t be losing the rest for long.
It’s fairly uncommon to have a four-trade losing run. Experienced traders have streaks that are comparable or even longer.
They are successful because they employ less leverage.
Most people cap their leverage at 5:1, but they rarely go that high and usually stay around 3:1.
Another factor that contributes to experienced traders’ success is that their accounts are appropriately capitalized!
While mastering technical analysis, fundamental analysis, sentiment analysis, establishing a system, and trading psychology are all important, we feel the most critical aspect in whether you succeed as a forex trader is ensuring that you adequately capitalize your account and trade that capital with appropriate leverage.
Your chances of success are considerably lowered if you do not have minimum beginning money. On a tiny enough account, it is impossible to counteract the impacts of leverage.
Low leverage combined with correct capitalization allows you to realize very tiny losses, allowing you to not only sleep at night but also trade the next day.
Bill establishes a $5,000 account and trades 100,000 lots. He is using a leverage of 20:1.
On a daily basis, the currency pairings he regularly trades move anywhere from 70 to 200 pips. He employs tight 30 pip stops to defend himself.
If prices move 30 pips against him, he will be stopped out for a $300.00 loss. Bill believes that 30 pips is appropriate, but he underestimates the volatility of the market and is regularly stopped out.
Bill has had enough of being stopped out four times. He decides to give himself a bit more breathing room, deal with the fluctuations, and raise his stop loss to 100 pips.
The leverage of Bill is no longer 20:1. His account is down to $3,800 (due to four $300 losses) and he is still trading one 100,000 lot.
His leverage is now greater than 26:1.
He chooses to increase his stop loss to 50 pips. He initiates another trade with two lots and loses $1,000 two hours later when his 50 pip stop loss is hit.
He now has a balance of $2,800 in his account. His leverage is greater than 35:1.
He tries once more with two lots. The market rises by 10 pips this time. He walks away with a $200 profit. His account balance rises marginally to $3,000.
He creates a new position with two lots. The market falls 50 points, and he exits. He now has $2,000 left.
“What the hell?!” he exclaims. and opens another position.
The market then drops another 100 pips.
He only has $1,000 margin available because he has $1,000 locked up as a margin deposit, therefore he receives a margin call and his position is quickly liquidated!
He now has $1,000 remaining, which isn’t even enough to start a new job.
He lost $4,000, or 80% of his money, in a total of eight trades, while the market moved only 280 pips. 280 pips! The market moves 280 pips quite easily.
Do you see why leverage is the number one killer of forex traders?