Forex Tip - Understand Leverage Or Die

Forex Tip - Understand Leverage Or Die

Most traders, usually newbies, focus on things such as trading strategy, charts and indicators. Important elements, no doubt. But lots of forex "victims" miss a crucial point that literally kills their accounts in the first 3 months of trading - they don't understand LEVERAGE. Leverage is the ratio between the actual size of the position and the amount of money the trader needs to deposit (or set aside) in order to control the position (margin). For example, if the position size is $100,000 and the margin is $1,000, the leverage is 1:100. It means that in order to "play" with $100,000 the trader needs to set aside only $1,000 for margin. If the leverage is 1:200, the trader will be able to control $100,000 with only $500 and so on. Some forex brokers offer leverage up to 1:400. But leverage can kill you. And that will be a quick and painful death.

Let's take two typical traders for example. They both have the same amount of money in their account -- $10,000. They both use the same trading system and for the sake of illustration they even place the same orders at the same time with the same currency pair -- EUR/USD.

Andy uses 1:25 leverage and trades one regular lot ($100,000). He goes long on the EUD/USD with a 50 pips stop loss order. Andy's margin for this position is $4000. Ron, on the other hand, wants to maximize his profits. He uses the highest leverage offered by his broker -- 1:400. This leverage enables him to trade 10 regular lots ($1,000,000). That's a lot, and Ron becomes a little bit greedy. But hey, he is here to make money. And the margin is only $2,500. So he goes long on the EUR/USD with a 50 pips stop loss, like Andy.

The market goes against the poor traders and the stop loss are hit. Andy's loss is $500. He still has $9,500 in his account so he easily moves to the next trade. What about Ron? He lost in this single trade $5,000. This is half of his account! What a slap in the face, from which he might not recover mentally. If he does not change his money management and risk management, the high leverage will kill his account very shortly. Maybe even in the next trade. It does not mean that Ron cannot analyze the market or cannot spot good trading opportunity when it comes. It only means that he does not trade to survive. And in order to survive the forex market you need to fully understand the implications of high leverage.

So regardless of what your broker tries to sell you, pay close attention to your money and risk management and do not leverage too much. Because as shown in the example above, the temptation to leverage might be lethal.

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