 |
An uninformed trader perceives a leverage of 100:1 or 200:1 as a way to riches, whereas many serious authors in the Forex world advocate leverage as low as 3:1. Why is there this huge difference? Lets see if we can discover the reason. What is the basic meaning of leverage in the Forex market? It simply means to borrow money to trade. As an example, you have a $2,000 mini account and you trade long one lot of the USD/JPY. One mini lot controls $10,000 of currency, so you are borrowing $10,000 from your broker, secured by your $2,000 account balance. Mathematically, the equation to calculate leverage is: Transaction Value / Account Balance = Leverage Expressed as a ratio: Thus, $10,000 / $2,000 = 5 Or, in your trade, you are leveraged 5:1 But, you say: “My broker advertised that I can trade at a leverage of 200:1 in this account. I’m not getting my money’s worth, am I?” Well, lets see what happens if you do make this trade at a leverage of 200:1. Using the equation as before lets determine how many lots you could trade. Transaction Value / $2,000 = 200 Solving for Transaction Value yields $400,000 and since one lot is worth $10,000, you are trading 40 lots! If you follow the general rule of thumb that says don’t risk more than 3% - 5% of your assets on any one trade (lets use 4%), you must hold your risk to 4% of $2,000 which is $80. Because you have 40 lots, your risk, which is controlled by your stop, can be no more than 2 pips. If that is equal or less than your broker’s spread, perhaps you won’t even be able to place this trade. This is something to seriously consider, isn’t it? How do you feel about a stop only 2 pips away from your entry? Likely to get stopped out? You bet! What’s going on here? Does this mean that leverage is all just a ruse? Is it only a bunch of hype by the broker to entice us to make large trades so that they can make lots of money at our expense? Not really. Leverage is good, provided that you understand it. And understanding it means that you realize that you don’t need to trade at those levels at all. Consider the following trade: You still have that same $2,000 mini account and again, are trading long one lot of the USD/JPY. But now, with $80 as your risk (same 4% of your assets as before), you can go as high as 80 pips for your stop. Ultimately, your trade is successful and you profit by 100 pips, or $100. Now, $100 profit on a trade that controlled $10,000 may not seem like much; in fact, it’s only 1% return. But consider, on the $2,000 you actually have invested here, your return is 5%. Not too bad for a single, small trade, in what was probably a short time span. Consider also the power of compounding and think of where you can be if you can consistently perform the magic of this trade 2 or 3 times a week. Do you see where I am going? And this is with leverage of 5:1. OK, let me summarize: Leverage, as seen by the broker, is the maximum borrowing that he will allow in your account. If he advertises you can leverage your account 200:1, that means he will allow you that, but no more. But, it does not mean you are required to trade with a leverage of 200:1. Leverage, as seen by the trader, is the value of your transaction divided by the value of your account, expressed as a ratio. This means you can trade at any leverage you desire, up to the maximum that is permitted by the broker. You control leverage by the selection of the number of lots you choose to trade and the amount of your account Index of Other Forex Trading Articles
"I feel totally empowered and humble all at the same time. If everyone learned from you guys, it might get a lot more difficult to make money in the Forex. Last week, using Chris's basic guidance I captured 300+ pips"
|
|
