Leverage: How Does it Really Affect a Forex Account?
The attraction of forex and other financial derivative instruments is that a trader can use leverage, and the level of leverage that can be used in forex is higher than in the stock market. Leverage allows a trader to use a small amount of money to trade the markets, as the brokers will usually supply a large part of the traded capital for each trade.
The perception behind the use of leverage which sees the broker's equity as “free money” is actually responsible for the misapplication of leverage by traders. Forex leverage is a double edged sword, and in this missive, we will look at just how sharp this double edge Forex sword leverage can be.
The movement of currencies is measured in pips, which in the real sense, is just a movement of a fraction of a cent. The change of movement is measured as a 4th/5th decimal point, or as a 2nd/3rd decimal point (for Yen crosses), depending on whether the broker uses 4 or 5 digit pricing. For such movements to make any real financial sense, Forex transactions must be carried out in large volumes. That is why a Standard Lot of currency trade starts from $100,000. How many retail traders have up to $100,000 in their accounts, or the ability to commit that amount of money to A SINGLE Forex trade? Virtually none. This is why brokers now provide the shortfall in equity in the form of leverage so that traders can trade. Profits can then be significant enough to make sense. Unfortunately, if traders use leverage and suffer losses in trades, they also have to absorb all the losses too.
When we speak of leverage, we talk in terms of real leverage and margin leverage. Margin leverage refers to the percentage of the trader's capital to the broker's capital, while real leverage refers to the trade size which the trader uses as a result of the margin leverage he has set. Setting a high margin leverage (e.g. 1:500) enables the trader to use a high real leverage. The degree of profits or losses increases with the use of higher real leverage. Let us use the example of two traders, Trader Mike and Blake, to illustrate this point.
Both traders have capital of $1,000, both use the same broker with the same margin deposit requirements, and both decide to short the EURUSD at 1.2920.
Trader Mike applies a real leverage of a factor of 50 and shorts the EURUSD with 0.5 lots ($50,000), while Trader Blake opts to short the EURUSD with 0.1 lots ($1,000). Contrary to their expectations, the EURUSD went bullish and triggered the stops that both traders had set at 1.2970.
One pip of the EURUSD is worth $1 for a single mini-lot trade and $5 for a trade worth half a standard lot. Trader Mike lost 50 pips on the trade, for a loss of $250. This is a loss of one-quarter of the trading account, which is quite colossal. Trader Blake only suffered a loss of $50.
We can see from this example that Trader Mike, who used 0.5 lots, lost big while Trader Blake sustained minor losses.
This shows that traders must be careful when setting margin leverage. Using a standard margin leverage of 1:100 (or 1:50 in the US) will force the trader to reduce his trade size, which in turn allows the trader to use wider stops so as to enable the trade to breathe. On the other hand, using a leverage of 1:400 or 1:500 will tempt the trader to use larger lot sizes, or to open several positions, which will all have the same effect: the account will be stressed and a loss will harm the account greatly.
So when using leverage, stick to the following:
- Use a leverage of not more than 1:100.
- Calculate your position size so that the market exposure does not exceed 5% of the account.
- Make sure your account is properly funded so that you are not forced to use excessively high leverage.