Failing to manage Forex leverage is one of the biggest pitfalls
currency traders face. While trading with leverage can significantly
enhance returns, it also increases the risk of big losses when a trade
fails. The currency market allows traders leverage of as much as 400:1,
meaning that for every $1 in your trading account, you can trade $400
using borrowed money.
However, most traders generally use much
smaller leverage of around 2:1, meaning that if they have $50,000 in
their trading account, they can make trades of as much as a total of
$100,000.
If you are not sure of how much leverage you are
currently using on your trading account, here is a simple formula for
computing it: take the amount of your total open positions and then
divide by the amount of money in your trading account. Thus, if your
open positions are worth $60,000 and you have $10,000 in your trading
account, your effective leverage is 6.
Now that you know how much
leverage you are using, you can determine if it is appropriate for your
trading style. If you are an aggressive trader with a high risk
tolerance, you can trade using leverage of as much as 10:1. On the other
hand, if you are more conservative, you might want to consider using
leverage of just 2:1 or 3:1.
Generally, most brokers advise
traders to use less leverage rather than more, simply because a few
losing trades can easily wipe out your trading account, leading to a
margin call or the loss of your positions.
For example, if you
have $10,000 in your trading account and you use 100:1 leverage to trade
10 mini-lots worth $10,000 or $1,000,000 in all, a 100 pip loss will
cost you $10,000 or wipe out your trading account.
On the other
hand, if you use leverage of just 10:1, you can trade just 5 mini-lots
or $100,000, and a similar loss will cost you just $5,000, which will
still leave $5,000 in your account.
Another reason why you might
want to use less leverage is to reduce your transaction fees. For
example, if your trade has a five pip spread, your transaction cost will
be around $500 or some 5% of your trading account.
This means
that even before you've made a profit on your trade, you already have to
make up the $500. The higher the leverage you use, the higher your
transaction cost, and vice-versa.
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