New traders sometimes make the error of using too much leverage without attention to the amount of their account balance, which can have disastrous consequences for their trading results. A trader’s money can be quickly wiped out if they don’t pay attention to the downside danger of excessive leverage.
With leverage, one can raise their trading position beyond what they could do with just their account balance cash. It allows traders to profit from even the smallest fluctuations in the value of currency pairs. Because it may magnify gains as well as losses, traders must decide how much risk they are willing to take on when using it.
For the most part, forex brokers require at least a 1% deposit margin to be placed in a trading account. Because of this, if you take a loss when using leverage, your losses are compounded in the same proportion that they would be if you made a profit. With no risk management plan, many traders lose all the funds held in their trading account in one trade.
Calculating leverage
Working example
Let’s say your account has a balance of $2000, and you’re using a leverage ratio of 1:100. You’ve made the decision to buy the GBPUSD pair with a 1000-unit volume, with your position opened when the price is at 1.3600. You then place your Stop Loss at 1.2600. This position requires a margin of £10,000 multiplied by 1/100 multiplied by 1.360, which comes to $136.
There’s a difference of 100 pips between the opening price and your stop loss. You’ll lose $100 if the market moves in the opposite direction as the 10,000 trading volume means that one pip equals $1. Without a stop loss order, you run the risk of losing more than $100, depending on when you decide to close your trade.
What is a reasonable leverage ratio for a new trader?
Most new traders focus on the possible rewards from utilizing high leverage, while more experienced traders avoid it because of the potential losses that come with it.
There is a great deal of flexibility that comes with the leverage offered by forex brokers, but it is the trader’s responsibility to determine what they are comfortable with.
Consider a trader with $10,000 in their account who wishes to employ leverage of 100:1. Having $1000,000 in leveraged trade means he can trade ten standard lots. Therefore, each time a pip moves, the trader makes or loses $100. He may have set his protective stop-loss ten pips from the entry price, making it a relatively well-covered trade.
If the market moves against him and triggers the stop loss, he would incur a loss of $1,000, which is equivalent to 10% of his trading capital. You can therefore see the high level of risk that you can easily be enticed to take. This is a lot more risk than you should take if you employ a good risk management approach.
You should use as little leverage as possible as a beginner until you have developed a trading strategy that generates at least 75% of profitable trades.
As a result, traders must balance their financial capacity with profit objectives and risk tolerance. Instead, find a middle ground and remember that choosing leverage is just one part of a well-rounded trading strategy.
Traders who are new to the market should stick with a lower ratio, such as 1:10. To begin trading in the financial markets, you should have at least USD 10,000 on hand. But what should you do if your starting capital is little and leverage of 1:10 isn’t sufficient for you?
- Avoid taking out loans to boost your deposit. Trading with borrowed money is riskier than using more leverage to make more money.
- Make a choice between big profit potential and low risk. Consider this, and decide how much leverage you’ll have. Keep in mind that as the stakes get higher, the more serious the risks become, but also the greater the potential reward.
- Trade using a pre-tested strategy with a high probability of success.
- Pay close attention to your financial management guidelines. Assess the deposit currency’s risk as well as your leverage when figuring out how much you’ll spend on a trade.
General precautionary measures when using leverage
Invest or trade with leverage that is appropriate for your level of expertise: If you are a novice trader, start with a lower level of leverage that you are comfortable with, such as 10:1, rather than attempting to replicate the high levels used by seasoned traders, such as 100:1.
Limit your losses: If you want to make a lot of money in the future, you must first understand how to minimize your losses so that you may stay in business longer and gain more knowledge.
Employ stop losses: These are an essential component of any trade, considering that markets often change trajectory within a blink of an eye, which can easily lead to massive losses if you slack off. Alternatively, you can use trailing stops to protect your profits even when you are away from your computer.
Don’t worsen a bad situation: A losing position cannot be turned around by simply adding more money to it. The idea of holding onto a lost trade and risking more of your money in the hopes that things may turn around is absurd. At some point, the loss will be so big that it overwhelms you. So, know when to close shop.
In summary
When you trade with a reasonable degree of leverage, you have the freedom to employ a wider stop loss. High leverage, on the other hand, increases your risk of losing more than you bargained for because it eats up your profit margin much faster. It also limits the flexibility of your stop loss, leaving you with a small chance of profiting.
In order to meet your trading needs, leverage is adjustable and may be tailored to fit your preferences. Further borrowing is an option, but it has a fee attached to it that you should be aware of. Therefore, you don’t have to raise your risk by trading large positions using borrowed money just because your broker offers such an opportunity.
