Forex newcomers are often poorly educated about one of the key concepts of the industry- leverage. What is it and how much Trading Leverage should you use?
15 February, Xtrade – First-time Forex traders are often intimidated by the charts and technical jargon that are the stock-in-trade of Forex trading, but what’s far more likely to trip up newcomers is leverage. Again and again, first-time traders lose money because they didn’t take the time to study leverage—what it is and how it works.
How much Trading Leverage should you use?
Don’t be like these traders. Take a minute to read about leverage in Forex trading. In this article, we’ll discuss the risks of high leverage in Forex trading, strategies to offset risk, and how to pick the right level of leverage.
Examples of Leverage
In Forex trading, leverage is the process by which a trader borrows money from his broker in order to trade. Many brokers offer unbelievably high leverage, sometimes as high as 400:1. What this means is that a trader making a deposit of $250 will control approximately $100,000 of currency ($250 X 400 = $100,000). In 2010, US regulators limited US-based traders to leverage of 50:1, which still comes out to $12,500.
So, what level of leverage should you choose? Low leverage of 5:1, or significantly higher leverage of 100:1? Before we answer that, let’s take a minute to look at how much you can gain or lose with various leverage levels.
Let’s begin with the relatively high leverage of 50:1. Trader X opens an account with $10,000. With the leverage of 50:1, he has $500,000 with which to trade. Now, in Forex trading, $500,000 is equal to 5 standard lots (trade sizes). Price movements are measured in pips, with each 1-pip movement in a standard forex lot equalling 10 units of change.
Don’t stop reading!
This is not as complicated as it sounds. In fact, what this means is that because Trader X bought 5 standard lots, each movement of 1 pip will cost $50 (do the math: $10 X 5 lots). In the event that the trade goes against Trader X, he would lose $2,500 ($50 X 50 pips = $2,500).
Now, let’s move on to lower leverage. Trader Y is more prudent and chooses leverage of 5:1. She, too, opens an account with $10,000. With the leverage of 5:1, she can trade with $50,000; and because $50,000 is less than a standard lot of $100,000, her lots will be measured in mini lots, with each mini lot equalling $10,000. In a mini lot, a pip equals $1. Trader Y has 5 mini lots, so each pip will equal a change of $5. Should her trade move against her by 50 pips, Trader Y will lose 50 pips, or $250 (50 X $5 = $250).
Yes, these numbers are tedious, but remember: leverage is the foundation of Forex trading. You’ll get burned if you don’t understand how it works. Go over the 2 examples we discussed above until you’re certain you understand them.
Choosing the Right Level Leverage
Prudent traders will tell you that there are 3 rules to follow when deciding on leverage. These are:
- Keep it low
- Use Stop Loss/Take Profit orders to reduce risk.
- Limit capital to no more than 2% of trading capital.
If you’re new to trading, be prudent and cautious: choose a low leverage level, e.g., 5:1 or 10:1; if your appetite for risk is larger, use a higher leverage level. Whatever you do, never risk money you cannot afford to lose.
Study examples of leverage before opening your first trade. You’ll lose money of you don’t. Choose a low level of leverage, be conservative, and use Stop Loss/take Profit orders. This is the best way to gain experience in Forex trading.
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For more information, please contact Kyley Picov at [email protected]
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