Most beginners underestimate the potentially devastating damage leverage can wreak on their accounts.
Understanding leverage enough to know when to use it and when NOT to use it is critical to your success!
Leverage is a very powerful tool but both old and new traders use it to destroy their trading capital simply because they take its destructive force too lightly or ignore it altogether.It’s a pity, but the more of them there are, the easier it is for us smart traders to make money. Sad but true.
Always keep in mind these words from a famous superhero:
“With great power comes great responsibility.”
Or something to that effect. Come on, we know you’ve seen that movie. Here’s a clue:
Anyway, high leverage is a favorite selling point for most forex brokers.Yes, they pitch that you can make a huge killing using huge leverage, but also know that you could easily be killed by huge leverage as well.
Most brokers want you to trade with a short-term mindset.
They want you to trade as much as possible as often as possible.
It’s the only way they make money. One or two pips are important to them.
The more you trade the more they make on the spread.
It’s not in their best interest to tell you to let your trades run longer than the same day.
If you want to give yourself the best chance to succeed, first learn to trade profitably without leverage.
Play it safe. Protect your capital.
When you can consistently make more pips more than you lose then, and only then, should you use unleash this weapon of mass destruction called leverage.
Destroy traders taking the opposite side of your trade. Don’t destroy yourself.Forex trading should be treated as a job or business.
Don’t think that just because brokers allow you to use high leverage with a low minimum deposit that you can “make a quick ” or “get rich quick”. Approach the currency markets with respect.
Be realistic in your expectations and be willing to properly educate yourself.
As a trader, it is crucial that you understand both the benefits AND the pitfalls of trading with leverage.
Using a ratio of 100:1 as an example means that it is possible to enter into a trade for up to $100 for every $1 in your account.With as little as $1,000 of margin available in your account, you can trade up to $100,000 at 100:1 leverage.
This gives you the potential to earn profits on the equivalent of a $100,000 trade!
It’s like a super scrawny dude who has a super long forearm entering an arm-wrestling match.
If he knows what he’s doing, it doesn’t matter if his opponent is Arnold Schwarzenegger, due to the leverage that his forearm can generate, he’ll usually come out on top.
When leverage works, it magnifies your gains substantially. Your head gets BIG and you think you’re the greatest trader that has ever lived.
But leverage can also work against you.If your trade moves in the opposite direction, leverage will AMPLIFY your potential losses.
You’ll be broke faster than Mike Tyson can chew your ear off.
Here’s a chart of how much your account balance changes if prices move depending on your leverage.
% CHANGE IN CURRENCY PAIR
% CHANGE IN ACCOUNT
Let’s say you bought USD/JPY and it goes up by 1% from 120.00 to 121.20.
If you trade one standard 100k lot, here is how leverage would affect your return:
% CHANGE IN ACCOUNT
Let’s say you bought USD/JPY and it goes down by 1% from 120.00 to 118.80.
If you trade one standard 100k lot, here is how leverage would affect your return (or loss):
% CHANGE IN ACCOUNT
The more leverage you use, the less “breathing room” you have for the market to move before a margin call.
You’re probably thinking, “I’m a day trader, I don’t need no stinkin’ breathing room. I only use 20-30 pip stop losses.”
Okay, let’s take a look:
You open a mini account with $500 which trades 10k mini lots and only requires .5% margin.
You buy 2 mini lots of EUR/USD.
Your true leverage is 40:1 ($20,000 / $500).
You place a 30-pip stop loss and it gets triggered. Your loss is $60 ($1/pip x 2 lots).
You’ve just lost 12% of your account ($60 loss / $500 account).
Your account balance is now $440.
You believe you just had a bad day. The next day, you’re feeling good and want to recoup yesterday losses, so you decide to double up and you buy 4 mini lots of EUR/USD.
Your true leverage is about 90:1 ($40,000 / $440).
You set your usual 30-pip stop loss and your trade losses.
Your loss is $120 ($1/pip x 4 lots).
You’ve just lost 27% of your account ($120 loss/ $440 account).
Your account balance is now $320.
You believe the tide will turn so you trade again.
You buy 2 mini lots of EUR/USD. Your true leverage is about 63:1.You set your usual 30 pip stop loss and lose once again! Your loss is $60 ($1/pip x 2 lots).
You’ve just lost almost 19% of your account ($60 loss / $320 account). Your account balance is now $260.
You’re getting frustrated. You try to think about what you’re doing wrong. You think you’re setting your stops too tight.
The next day you buy 3 mini lots of EUR/USD.
Your true leverage is 115:1 ($30,000 / $260).
You loosen your stop loss to 50 pips. The trade starts going against you and it looks like you’re about to get stopped out yet again!
But what happens next is even worse!
You get a margin call!
Since you opened 3 lots with a $260 account, your Used Margin was $150 so your Usable Margin was a measly $110.
The trade went against you 37 pips and because you had 3 lots opened, you get a margin call. Your position has been liquidated at market price.
The only money you have left in your account is $150, the Used Margin that was returned to you after the margin call.
After four total trades, your trading account has gone from $500 to $150.
A 70% loss!
Congratulations, it won’t be very long until you lose the rest.
STARTING ACCOUNT BALANCE
# LOTS OF USED
STOP LOSS (PIPS)
ENDING ACCOUNT BALANCE
A four-trade losing streak is not uncommon. Experienced traders have similar or even longer streaks.
The reason they’re successful is that they use low leverage.
Most cap their leverage at 5:1 but rarely go that high and stay around 3:1.
While learning technical analysis, fundamental analysis, sentiment analysis, building a system, trading psychology are important, we believe the biggest factor on whether you succeed as a forex trader is making sure you capitalize your account sufficiently and trade that capital with smart leverage.
Your chances of becoming successful are greatly reduced below a minimum starting capital. It becomes impossible to mitigate the effects of leverage on too small an account.
Low leverage with proper capitalization allows you to realize losses that are very small which not only lets you sleep at night, but allows you to trade another day.
Bill opens a $5,000 account trading 100k lots. He is trading with 20:1 leverage.
The currency pairs that he normally trades move anywhere from 70 to 200 pips on a daily basis. In order to protect himself, he uses tight 30 pip stops.
If prices go 30 pips against him, he will be stopped out for a loss of $300.00. Bill feels that 30 pips are reasonable but he underestimates how volatile the market is and finds himself being stopped out frequently.
After being stopped out four times, Bill has had enough. He decides to give himself a little more room, handle the swings, and increases his stop to 100 pips.
Bill’s leverage is no longer 20:1. His account is down to $3,800 (because of his four losses at $300 each) and he’s still trading one 100k lot.His leverage is now over 26:1.
He decides to tighten his stops to 50 pips. He opens another trade using two lots and two hours later his 50 pip stop loss is hit and he losses $1,000.
He now has $2,800 in his account. His leverage is over 35:1.
He tries again with two lots. This time the market goes up 10 pips. He cashes out with a $200 profit. His account grows slightly to $3,000.
He opens another position with two lots. The market drops 50 points and he gets out. Now he has $2,000 left.
He thinks “What the hell?!” and opens another position!
The market proceeds to drop another 100 pips.
Because he has $1,000 locked up as margin deposit, he only has $1,000 margin available, so he receives a margin call and his position is instantly liquidated!
He now has $1,000 left which is not even enough to open a new position.
He lost $4,000 or 80% of his account with a total of 8 trades and the market has only moved 280 pips. 280 pips! The market moves 280 pips pretty darn easy.
Are you starting to see why leverage is the top killer of forex traders?
Hopefully, we’ve done our job and you now have a better understanding of what “margin” is.
If you don’t know what margin is, or think it’s an alternative form of butter, please read our previous lessons.
Now we want to take a harder look at “leverage” and show you how it regularly wipes out unsuspecting or overzealous traders.Before we begin, let the image below haunt you about the negative effects of using too much leverage and running out of margin.
We’ve all seen or heard online forex brokers advertising how they offer 200:1 leverage or 400:1 leverage.
We just want to be clear that what they are really talking about is the maximum leverage you can trade with.Remember this leverage ratio depends on the margin required by the broker. For example, if a 1% margin is required, you have 100:1 leverage.
There is maximum leverage. And then there is your true leverage.
True leverage is the full amount of your position divided by the amount of money deposited in your trading account.
Let us illustrate with an example:
You deposit $10,000 in your trading account. You buy 1 standard 100K of EUR/USD at a rate of $1.0000. The full value of your position is $100,000 and your account balance is $10,000.
Your true leverage is 10:1 ($100,000 / $10,000)
Let’s say you buy another standard lot of EUR/USD at the same price. The full amount of your position is now $200,000, but your account balance is still $10,000.
Your true leverage is now 20:1 ($200,000 / $10,000)
You’re feeling good so you buy three more standard lots of EUR/USD, again at the same rate. The full amount of your position is now $500,000 and your account balance is still $10,000.
Your true leverage is now 50:1 ($500,000 / $10,000).
Assume the broker requires 1% margin.
If you do the math, your account balance and equity are both $10,000, the Used Margin is $5,000, and the Usable Margin is $5,000. For one standard lot, each pip is worth $10.
In order to receive a margin call, price would have to move 100 pips ($5,000 Usable Margin divided by $50/pip).
This would mean the price of EUR/USD would have to move from 1.0000 to .9900 – a price change of 1%.
After the margin call, your account balance would be $5,000.
You lost $5,000 or 50% and the price only moved 1%.
Now let’s pretend you ordered coffee at a McDonald’s drive-thru, then spilled your coffee on your lap while you were driving, and then proceeded to sue and win against McDonald’s because your legs got burned and you didn’t know the coffee was hot.
To make a long story short, you deposit $100,000 in your trading account instead of $10,000.
You buy just 1 standard lot of EUR/USD – at a rate of 1.0000. The full amount of your position is $100,000 and your account balance is $100,000. Your true leverage is 1:1.
Here’s how it looks in your trading account:
In this example, in order to receive a margin call, price would have to move 9,900 pips ($99,000 Usable Margin divided by $10/pip).
This means the price of EUR/USD would have to move from 1.0000 to .0100! This is a price change of 99% or basically 100%!
Let’s say you buy 19 more standard lots, again at the same rate as the first trade.
The full amount of your position is $2,000,000 and your account balance is $100,000. Your true leverage is 20:1.
In order to be “margin called”, the price would have to move 400 pips ($80,000 Usable Margin divided by ($10/pip X 20 lots)).
That means the price of EUR/USD would have to move from $1.0000 to $0.9600 – a price change of 4%.
If you did get margin called and your trade exited at the margin call price, this is how your account would look like:
You would have realized an $80,000 loss!
An $80,000 loss!
You would’ve wiped out 80% of your account and the price only moved 4%!
And you would probably look like something like this.
Do you now see the effects of leverage?!
Leverage amplifies the movement in the relative prices of a currency pair by the factor of the leverage in your account.
Margin can be thought of as a good faith deposit or collateral that’s needed to open a position and keep it open.
Margin trading gives you the ability to enter into positions larger than your account balance.
Although buying and selling on margin does not provide leverage in and of itself, it can be used as a form of leverage.
This is because the amount of margin you are allowed to take out typically depends on how much money you have in your account.
Trading currencies on margin let you increase your buying (and selling) power.
This means that if you have $5,000 cash in a margin account that allows 100:1 leverage, you could trade up to $500,000 worth of currency because you only have to post one percent of the purchase price as collateral.Another way of saying this is that you have $500,000 in buying power.
With more buying power, you can increase your total return on investment with less cash outlay. But be careful, trading on margin magnifies your profits AND losses.
All traders fear the dreaded margin call.
It’s not a great feeling.
This occurs when your broker notifies you that your margin deposits have fallen below the required minimum level because an open position has moved against you too much.While trading on margin can be profitable, it is important that you take the time to understand the risks.
Make sure you fully understand how your margin account works, and be sure to read the margin agreement between you and your broker.
Always ask any questions if there is anything unclear to you in the agreement.
Your positions could be partially or totally liquidated should the available margin in your account fall below a predetermined threshold.
You may not receive a margin call before your positions are liquidated (the ultimate unexpected birthday gift).
In the event that money in your account falls below margin requirements (usable margin), your broker will close some or all open positions.
This can help prevent your account from falling into a negative balance, even in a highly volatile, fast-moving market.
Margin calls can be effectively avoided by monitoring your account balance on a very regular basis and by utilizing stop loss orders on every open position to limit risk.
Keep in mind though that your stop loss may experience massive slippage when the market is moving fast!
The topic of margin is a touchy subject and some argue that too much margin is dangerous. It all depends on the individual and the amount of knowledge and training he or she has.If you are going to trade on a margin account, it’s vital that you know what your broker’s policies are on margin accounts and that you understand and are comfortable with the risks involved.
You should also know that most brokers require a higher margin during the weekends. This may take the form of 1% margin during the week and if you intend to hold the position over the weekend it may rise to 2% or higher.
Brokers also may have different margin requirements for different currency pairs so pay attention to that as well!
Assume you are a successful retired British spy who now spends his time trading currencies. You open a mini account and deposit $10,000.
When you first log in, you will see the $10,000 in the “Equity” column of your “Account Information” window.
You will also see that the “Used Margin” is $0.00, and that the “Usable Margin” is $10,000, as pictured below:
Your Usable Margin will always be equal to “Equity” less “Used Margin.”
Usable Margin = Equity – Used Margin
Therefore it is the Equity, NOT the Balance that is used to determine Usable Margin. Your Equity will also determine if and when a Margin Call is reached.
As long as your Equity is greater than your Used Margin, you will not have Margin Call.
( Equity > Used Margin ) = NO MARGIN CALL
As soon as your Equity equals or falls below your Used Margin, you will receive a margin call.
( Equity =< Used Margin ) = MARGIN CALL, go back to demo trading!
Let’s assume your margin requirement is 1%. You buy 1 lot of EUR/USD.
Your Equity remains $10,000. Used Margin is now $100 because the margin required in a mini account is $100 per lot. Usable Margin is now $9,900.
If you were to close out that 1 lot of EUR/USD (by selling it back) at the same price at which you bought it, your Used Margin would go back to $0.00 and your Usable Margin would go back to $10,000. Your Equity would remain unchanged at 10,000.But instead of closing the 1 lot, you (the adrenaline-junkie, chop-socky retired spy that you are) got extremely confident and bought 79 more lots of EUR/USD for a total of 80 lots of EUR/USD because that’s just how you roll.
You will still have the same Equity, but your Used Margin will be $8,000 (80 lots at $100 margin per lot). And your Usable Margin will now only be $2,000, as shown below:
With this insanely risky position on, you will make a ridiculously large profit if EUR/USD rises. But this example does not end with such a fairy tale.
Let us paint a horrific picture of a Margin Call which occurs when EUR/USD falls.
EUR/USD starts to fall. You are long 80 lots, so you will see your Equity fall along with it.
Your Used Margin will remain at $8,000.
Once your equity drops below $8,000, you will have a Margin Call.
This means that some or all of your 80 lot position will immediately be closed at the current market price.
Assuming you bought all 80 lots at the same price, a Margin Call will trigger if your trade moves 25 pips against you.
Humbug! EUR/USD can move that much in its sleep!
How did we come up with 25 pips? Well, each pip in a mini lot is worth $1 and you have a position open consisting of 80 freakin’ mini lots. So…
$1/pip X 80 lots = $80/pip
If EUR/USD goes up 1 pip, your equity increases by $80.
If EUR/USD goes down 1 pip, your equity decreases by $80.
$2,000 Usable Margin divided by $80/pip = 25 pips
Let’s say you bought 80 lots of EUR/USD at $1.2000. This is how your account will look if it EUR/USD drops to $1.1975 or -25 pips.
As you can see, your Usable Margin is now at $0.00 and you will receive a MARGIN CALL!
Of course, you’re a veteran international spy and you’ve faced much bigger calamities.
You’ve got ice in your veins and your heart rate is still 55 bpm.
After the margin call this is how your account will look:
EUR/USD moves 25 PIPS, or less than .22% ((1.2000 – 1.1975) / 1.2000) X 100% and you LOSE $2,000!
You blew 20% of your trading account! (($2,000 loss / $10,000 balance)) X 100%
In reality, it’s normal for EUR/USD to move 25 pips in a couple seconds during a major economic data release, and definitely that much within a trading day.
Oh, we almost forget…we didn’t even factor in the SPREAD!
To simplify the example, we didn’t even factor in the spread, but we will now to make this example super realistic.
Let’s say the spread for EUR/USD is 3 pips. This means that EUR/USD really only has to move 22 pips, NOT 25 pips before a margin call.
Imagine losing $2,000 in 5 seconds?!This is what could happen if you don’t understand the mechanics of margin and how to use leverage.
The sad fact is that most new traders don’t even open a mini account with $10,000.
Because you had at least $10,000, you were at least able to weather 25 pips before his margin call.
If you only started off with $9,000, you would have only been able to weather a 10 pip drop (including spread) before receiving a margin call. 10 pips!
Let’s discuss leverage and margin and the difference between the two.
What is leverage?
We know we’ve tackled this before, but this topic is so important, we felt the need to discuss it again.
The textbook definition of “leverage” is having the ability to control a large amount of money using none or very little of your own money and borrowing the rest.
For example, to control a $100,000 position, your broker will set aside $1,000 from your account. Your leverage, which is expressed in ratios, is now 100:1.
You’re now controlling $100,000 with $1,000.
Let’s say the $100,000 investment rises in value to $101,000 or $1,000.
If you had to come up with the entire $100,000 capital yourself, your return would be a puny 1% ($1,000 gain / $100,000 initial investment).
This is also called 1:1 leverage.
Of course, I think 1:1 leverage is a misnomer because if you have to come up with the entire amount you’re trying to control, where is the leverage in that?
Fortunately, you’re not leveraged 1:1, you’re leveraged 100:1.The broker only had to put aside $1,000 of your money, so your return is a groovy 100% ($1,000 gain / $1,000 initial investment).
Now we want you to do a quick exercise. Calculate what your return would be if you lost $1,000.
If you calculated it the same way we did, which is also called the correct way, you would have ended up with a -1% return using 1:1 leverage and a WTF! -100% return using 100:1 leverage.You’ve probably heard the good ol’ clichés like “Leverage is a double-edged sword.” or “Leverage is a two-way street.”
As you can see, these clichés weren’t lying.
What is margin?
So what about the term “margin”? Excellent question.
Let’s go back to the earlier example:
In forex, to control a $100,000 position, your broker will set aside $1,000 from your account. Your leverage, which is expressed in ratios, is now 100:1. You’re now controlling $100,000 with $1,000.
The $1,000 deposit is “margin” you had to give in order to use leverage.
Margin is the amount of money needed as a “good faith deposit” to open a position with your broker.
It is used by your broker to maintain your position. Your broker basically takes your margin deposit and pools them with everyone else’s margin deposits, and uses this one “super margin deposit” to be able to place trades within the interbank network.
Margin is usually expressed as a percentage of the full amount of the position. For example, most forex brokers say they require 2%, 1%, .5% or .25% margin.
Based on the margin required by your broker, you can calculate the maximum leverage you can wield with your trading account.
If your broker requires a 2% margin, you have a leverage of 50:1.
Here are the other popular leverage “flavors” most brokers offer:
Aside from “margin requirement”, you will probably see other “margin” terms in your trading platform.
There is much confusion about what these different “margins” mean so we will try our best to define each term:
Margin requirement: This is an easy one because we just talked about it. It is the amount of money your broker requires you to open a position. It is expressed in percentages.
Account balance: This is just another phrase for your trading bankroll. It’s the total amount of money you have in your trading account.Used margin: The amount of money that your broker has “locked up” to keep your current positions open.
While this money is still yours, you can’t touch it until your broker gives it back to you either when you close your current positions or when you receive a margin call.
Usable margin: This is the money in your account that is available to open new positions.
Margin call: You get this when the amount of money in your account cannot cover your possible loss. It happens when your equity falls below your used margin.
If a margin call occurs, some or all open positions will be closed by the broker at the market price.
Most professional forex traders and money managers trade one standard lot for every $50,000 in their account.
If they traded a mini account, this means they trade one mini lot for every $5,000 in their account.Let that sink into your head for a couple seconds.
If pros trade like this, why do less experienced forex traders think they can succeed by trading 100K standard lots with a $2,000 account or 10K mini lots with $250?
No matter what the forex brokers tell you, don’t ever open a “standard account” with just $2,000 or a “mini account” with $250.
Heck, some even allow you to open accounts with just $25!The number one reason new traders fail is not because they suck, but because they are undercapitalized from the start and don’t understand how leverage really works.
Don’t set yourself up to fail.
We recommend that you have at least have $100,000 of trading capital before opening a standard account, $10,000 for a mini account, or $1,000 for a micro account.
Of course, open an account only when you are consistently good.
So if you only have $60,000, open a mini account. If you only have $8,000, open a micro account.
If you only have $250, open a demo account and stick with it until you come up with the additional $750, then open a micro account. If you have $1, find a job.
If you don’t remember anything else in this lesson, at least remember what you just read above.
Okay, please re-read the previous paragraph and ingrain it in your memory. Just because brokers allow you to open an account with only $25 does NOT mean you should.
We believe most new traders who open a forex trading account with the bare minimum deposit do so because they don’t completely understand what the terms “leverage” and “margin” really are and how it affects their trading.
It’s crucial that you’re fully aware and free of ignorance of the significance of trading with leverage.
If you don’t have rock solid understanding of leverage and margin, we guarantee that you will BLOW YOUR TRADING ACCOUNT!