This is a very important question since leverage is what makes the Forex market so attractive to traders. We answered this in our Quora space since it has appeared multiple times in various forms, and felt our community would benefit here at Stonehill Forex.
Not a Great Idea
Many non-US brokers offer leverage up to 1000:1 and even higher to lure people into the attractive and potentially profitable world of FOREX trading. And, it works!
Unsuspecting individuals with limited understanding of how leverage works (or trading the spot currency market for that matter) open an account, deposit their margin and immediately place a trade…only to get stopped out in minutes. How did that happen?
What Does it All Mean
The issue is that many new traders really don’t understand how leverage can work both for and against you. Before we get into some examples, let’s understand what leverage means.
Simply stated, leverage is the ability to get a lot for a little. Looking at the picture below, notice how the small amount of “Deposit” can support a much larger amount called the “Buying Power” by positioning the leverage. The smaller the leverage, the less buying power you have and conversely, the higher the leverage, the more you can buy.
Show me Some Numbers
We’ll use numbers to explain it in easy terms and then suggest a safe, yet income providing leverage ratio.
Let’s start with an easy ratio; 100:1. What this means is that for $1, you can control $100. That means that you only have to put up $1000 of margin to control $100,000, or one full lot of, let’s say, the EUR/USD. Each pip movement (the smallest whole measurable amount) would net (or lose) $10 depending on the direction of your trade. So that being said;
Leverage = 100:1
$1000 controls $100,000
1 pip movement = $10
A 20 pip trade = $200
Now, let’s change that leverage to 1000:1, or 10x what we first looked at. The same trade would only cost you $100 of margin to control $100,000 and each pip movement would be worth $100. So that being the case;
Leverage = 1000:1
$100 controls $100,000
1 pip movement = $100
A 20 pip trade = $2000
How wonderful it would be to get into a quick 20 pip trade with only a $100 and walk away with $2000, right?
Simply put, unless you have a very healthy account in the mid-six digit range, this kind of trade is account suicide waiting to happen.
Let’s Get Real
You are fortunate enough to have $5000 to trade, and you follow the 2% risk profile – which is what we (and most of the industry suggests)…that works out to risking, well, $100 – because $5000 x .02% = $100.
So at that 1000:1 leverage, you have enough margin to keep your trade alive for about 30 pips ($100 x 30 = $3000). But what about the other $2000? Brokers require a minimum amount of margin in your account at all times (which varies from broker to broker). Fall below that required amount, and you’ll either need to close your trade(s) or add more money – so you never get to use ALL of your margin.
Average True Range – Your Best Friend
At the time this answer was written, the Average True Range (ATR) of the EUR/USD on the hourly chart is about 11 pips. The average ATR on the daily chart is about 70 pips, and there are hourly candles which are in excess of 25 pips. If you’re not sure what the ATR is or how to use it, don’t worry – we’ll have a blog on that in the future. It’s also a HUGE part of the Stonehill Advanced Course.
If you were to open a trade in a moderately volatile period of the day, you could lose your account in a few minutes to a couple of hours. Even sooner if you’re not aware of a significant news report where price can spike upwards of 100 pips in a matter of minutes. If that spike goes the opposite direction of your trade, you’re done, kaput, out…
Remember, making money in the FOREX market is not a “get rich quick” endeavor. You need to be in it for the long game. If you’re having trouble wrapping your head around that concept, you need to first work on your trading psychology.
Now, the short answer is; use leverage of 20:1. Set it and forget it. You can do quite well, without the added stress of watching your account balance bottom out. If you want to read more about leverage, check out this article: Leverage
Until you are consistently profitable, have solid money management and an impeccable headspace with regard to trading psychology, use this leverage. Once you’ve attained more consistent profits, then by all means, consider moving it up a little, but remain very cautious if you approach the 50:1 level.
Just remember, with wonderful gains can come equally tragic losses, and if you want to read about how losses can affect your account, check out the following blog on our site: Trading Losses – How Much is too Much
More to Come
There’s a lot more to come. If you haven’t signed up on our contacts page or subscribed to the YouTube channel, please consider doing so to receive notifications as we continue to publish helpful, relevant, and informative Forex related material to support your quest to becoming a better trader.
To learn more about trading Forex, consider taking our advanced course. Click HERE for more information.
Our only goal is to make you a better trader.
BTW – Any information communicated by Stonehill Forex Limited is solely for educational purposes. The information contained within the courses and on the website neither constitutes investment advice nor a general recommendation on investments. It is not intended to be and should not be interpreted as investment advice or a general recommendation on investment. Any person who places trades, orders or makes other types of trades and investments etc. is responsible for their own investment decisions and does so at their own risk. It is recommended that any person taking investment decisions consults with an independent financial advisor. Stonehill Forex Limited training courses and blogs are for educational purposes only, not a financial advisory service, and does not give financial advice or make general recommendations on investment.