Today I will tell you what leverage is, why you need it and how to handle it properly.
What Is Leverage?
Billions of dollars go through Forex every day. Trading is conducted in lots. A standard lot is $100,000. Not every trader is able to invest such an amount, right?
Today, thanks to brokers, each person has access to the world currency market. They provide a kind of loan that increases your capital several times, allowing you to open a trade. This is basically the trading leverage. The size of the leverage indicates how many times your capital has been increased. With a deposit of $1,000 and leverage of 1:100, you can open a trade with a volume of 1 lot or $100,000.
Risks of Trading with Leverage
Most brokers today offer leverage from 1:1 to 1:1000. Some companies have raised their maximum leverage to 1:3000, but you should not consider this as an advantage. Yes, your profit will directly depend on your leverage: the higher it is, the more you will earn. However, if your trading predictions are wrong you may lose your entire investment in no time.
The cost of each pip depends on the volume of your transaction. Let's say your investment is $5,000. You choose 1:100 leverage and you open a trade with a size of $500,000, or 5 standard lots. With such a volume, 1 pip costs $50. If the market doesn’t move in your favor and drops by only 10 points, you will immediately lose $500.
Now let’s consider the same situation but with lower leverage size - 1:10. Imagine you open a $50,000 trade. In this example, 1 pip costs $5 and once the market moves 10 points against you, you will lose only $50.
In order to reduce potential risks you should always apply the following measures:
- Choose the right leverage size.
- Always set Stop Losses.
- Risk only 1-5% of your full investment in each transaction.
How to Set Correct Trading Leverage?
It should depend on two main indicators:
- Position size
- Position duration
We have already discussed how the volume of a transaction affects potential profit/loss. Look at the size of your deposit and decide what percentage of funds you plan to invest in a particular trade. Then calculate what leverage is required to open this particular transaction.
It’s even easier with the trade’s duration - the longer your trade lasts, the lower leverage you need:
- For short positions use the leverage from 1:50 to 1:1000
- For long positions, especially the ones that are held longer than a day, use the leverage of 1:50 and lower
How to Switch the Leverage Size?
Note that with the growth of your equity, the leverage will be changed automatically. The more funds you have on your account, the lower your leverage will be. This is done solely to secure your investments.
You might have an irresistible desire to earn maximum money in the shortest possible time. Fight this desire. Remember that small trading leverage has its advantages:
- You will reduce potential losses
- You can set a wider Stop Loss
I hope this article helps you to make your trading decisions more informed. At least regarding the choice of leverage.