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Leverage is a powerful, but often misunderstood trading tool that offers great potential for profit but also paves the way for substantial losses. Unfortunately, many Forex traders often focus on the former while ignoring the risk of the latter, and end up losing big amounts of money on their trades. The main thing that many of these traders fail to understand is that leverage is money that is borrowed from their brokers and thus, if their trade is unsuccessful, they not only suffer a loss but they also have to pay back the amount of the leverage.
The main reason why forex traders use leverage is to greatly boost their profits when price movements of currencies are just incremental. For example, let’s say you opened a position for the USD/EUR currency pair when the exchange rate was 1:0.88947. If the exchange rate went up to 1:0.89449 and you were able to afford a regular lot of 100,000 units of the base currency you were trading in, then you would make a profit of USD$502. On the other hand, if you could only afford a micro-lot of 1,000 units or a mini-lot of 10,000 units, then your profit would be only $5.02 and $50.20 respectively. If you used leverage, then you could invest in a standard lot with only $10,000 in your trading account (at a rate of 10:1).
How much leverage are you using? You can compute your effective leverage using a simple formula: simply divide the total amount of open positions that you have with the amount of equity in your trading account. Thus, if you have three open positions totaling $70,000 and your trading account has $10,000 then your effective leverage is 7:1.
One of the most important lessons that forex traders need to learn is how to use leverage most effectively. The big problem is that forex brokers may offer big amounts of leverage of as much as 50:1 or more and this is very tempting to traders who think they can make a huge profit on just one successful trade. But, of course this is a mistake, and many traders who suffer from big losses tend to react in two ways, both of which are undesirable. One is that they simply give up trading forex, and the other is that they continue to use high amounts of leverage in the hope that they would be able to make up their losses.
In general you should be more conservative with your use of leverage. The recommended amount of leverage is 10:1 or less depending on the size of your trading account. Keep in mind that the best traders make their money not from a single big trade but from a series of winning trades over time. In addition, the best traders actually focus on how much money they could potentially lose, not how much they could gain.
So keep an eye on your effective leverage and if it is higher than the recommended amounts, you can address it either by increasing their trading account or reducing their open positions.
Technical parts have been shared by Mr. Abdul, a Forex analyst from MTrading Egypt.
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