Sunday, February 25, 2018

Forex: The Truth about Leverage

July 26, 2010 by  
Filed under Forex Strategy, Money Management

Leverage is often being blamed by Novice Forex traders for losing money. It is being blamed so often that and they did not take a strategic moment to think what could be the problem really is.

For those who has no idea what is Leverage means in Forex trading. It is the amount of currency a trader can control relative to the amount of equity that trader possess in his or her trading account. Too complicated?

Let’s use an example:

Forex Brokers offer traders leverage 100:1. For each $1 the traders put in the broker account, they can control $100 to trade with. This amplify your profits and your loss, allowing anyone to trade with very little amount of money but reaping profits as if they possess large amount of cash.

Of course, when market go against the trader, the leverage will amplify the loss as if he or she possess that large amount of cash. The worst case situation will be the trader’s account will be wiped out.

Since leverage is able to cause us to loss so much money, even though we can make so much money from it. Why not reduce the leverage or demolish this function?

Let’s have another example and to ponder upon:

A trader has $10000 in his account. He trade with a $10000 lot size.

His maximum leverage is 10:1. The highest number of mini lots will be 6 if the trader want to buy GBP/USD.

Each pip would be worth $6 if they traded the maximum amount of GBP/USD.

The trader’s strategy is to have a risk allowance to 3% per trade. In this case, he is willing to risk $300 out of the $10000 on this trade. This also mean they wouldn’t able to risk their max amount unless the trade called for it’s stop to be at least 50 pips from the entry price.

$300 out of $10000? Big deal right? However, consider that the trader in the above example has already maxed out his equity. He isn’t able to enter another position until the current trade is closed. There are also a lot of other traders out there (including me) that has narrower stop loss than 50 pips in our strategy. If leverage is demolish entirely, the trader in the above example will have to distance of 500 pips from his entry price to stop loss to able to max out his 3% risk. This kills a lot of strategies.

It is easy to see that leverage is important as most strategies are using it to trade in the currency exchange. Trading will be very tough as there is no leverage to maximize all your trading opportunity. However, I don’t mean that you should get 1000:1 leverage and take as many lots position in your bank account. It isn’t strategically sound. In fact, it is suicidal!

But what is the true problem? The core issue for traders to become unprofitable? It is poor money management.

High leverage only reduce the amount of capital need to open a position. Trading with 100:1 leverage and 1000:1 leverage should not be any difference if you risk the same amount. The difference between 100:1 and 1000:1 is the amount of capital needed. 1000:1 isn’t riskier than 100:1 if you use proper money management.

Money management simply means that you should plan your entry and exit before making any trade. Only after establish the take profit and stop loss level, the trader then should set his lot size. The lot size should be adjusted so that the trader is able to risk the same amount of cash every trade.

If a forex trader plan his traders, risking the same small amount every time. Even with high leverage has no negative effect. But if we use very low or no leverage at all, it will limit everyone’s trading potential of success because most of the traders might not have enough cash to enter a position at all.

Leverage is not your enemy, nor is it your friend. It is a tool, like a double edge sword. Abuse it, it will cut you. Practice, learn from an experience teacher and you will wield this sword like a master. Learning, planning, strategize, and become a forex kung fu master.

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