Leverage is a hot topic in forex, especially among new traders. It’s often mentioned in educational articles as something newbies should avoid to protect themselves from excessive financial harm.
Leverage, which is also often referred to as margin trading, is the ability to magnify your trades. For instance, a $10 trade with 1:10 leverage is multiplied tenfold and ends up as a $100 trade. That also means all wins and losses are multiplied tenfold, so a $1 shift towards either side grows to $10.
It’s easy to see the appeal of this. Many traders rush into leverage, thinking that they can easily multiply their earnings. However, in most cases, these traders rapidly drain their accounts instead, sometimes suffering significant financial harm.
So does that mean traders should never leverage trades? Not exactly. Leverage is a tool like any other, and those who don’t get greedy and use it strictly, carefully, and with a plan can optimise their performance. Many pro and institutional traders, in fact, use leverage to better spread out their capital.
As such, it’s clear that leverage has its place in an average trader’s routine. The question to ask is how and when to use it, and how to avoid exposing yourself to too much risk while using it.
Using leverage as a new trader
Where most new traders get burned is by using all of the leverage a broker provides. Some brokers offer the ability to multiply your trades hundreds or even thousands of times, which can lead to irresponsible trading patterns.
Let’s think about it and take a small position of $10, as noted earlier. Now let’s apply 1:500 leverage to that position. The trade is now worth $5,000. That number may make the trader opening the position feel good, as traders often consider larger trades more gratifying.
But the next thing to consider is that a $1 loss becomes a $500 loss. In other words, if a trader has $1,000 in their account, for instance, this trade would wipe out half of that.
This is what many traders fail to recognise, and where many get frustrated with a big loss, pull away the funds they managed to save, and quit trading altogether.
Caution is necessary when employing leverage. Not just with the leverage itself, but in trading. The potency of margin trading largely depends on how competent the trader is overall. Since leverage only multiplies what’s already happening, it won’t magically improve your trading, it will only accelerate what’s already going on.
As such, if a forex trader loses more often than he wins, the leverage will only drain their account more quickly. However, even for a trader who manages to overcome the markets and break even or perhaps inch out some profits, forex leverage is dangerous. It has a significant emotional impact, and can make traders gun-shy, pulling them out of trades due to the increased risk. So, what’s the solution?
The basics of leverage use
As noted, new traders should probably hold off on using leverage until they have at least grasped the basics. That includes knowing terminology, learning the basics of handling a platform, being familiar with analysis and underlying market conditions, and having at least a rudimentary trading strategy.
In other words, traders should be able to stand on their own two feet, and preferably have a solid record in the markets. In that case, employing leverage won’t simply send them tumbling downwards faster.
Next, traders should be extremely careful with the amount of leverage they use. There’s nothing wrong with starting with small numbers like 1:2, 1:5, or 1:10. This is used to test out the waters and see if margin trading is even something you enjoy.
If it feels wrong, it stresses you out too much, or causes key negative emotions like fear and greed to well up, leverage may simply not be for you. That’s completely fine, leverage isn’t for everyone, and it isn’t necessary for becoming a competent trader.
However, if a trader finds they enjoy the relatively larger portion sizes, they may decide to employ leverage in their day-to-day trading. The next step is doing so safely.
Risk management and leverage
The most dangerous thing about leverage is that it can drain funds quickly. The best way to mitigate that is through smart risk management practices. Mitigating risk is what it all comes down to, since the primary goal is to prevent losses. This article will present some of the basic tactics forex traders can employ.
Position size assessment
The primary thing to do when using leverage is to correctly assess the portion size. It should fit in a trader’s overall risk profile and not risk too much of the overall capital they have in their account.
Here, it’s also important to calculate possible profits and losses, and be aware of how much one is willing to withstand. There are many position size calculators available online, and they can be an immensely useful tool for this.
Traders may think that a position size calculator is excessive, since it’s easy for them to simply multiply their initial trade with the leverage they are using. And while this is true, traders who place multiple trades can save valuable time and mental energy, as well as avoid mistakes, by simply inputting the numbers into a free service that will come up with accurate results.
Take profits and stop losses
Once the position size is accurately assessed, traders should remember to employ take profits and stop losses to better control their leveraged positions. As noted, losses rack up quickly, especially with higher leverage numbers. As such, a momentary lapse in attention or judgment can cause significant harm to an account.
Take profits and stop losses (the latter of which are more important in this scenario) help traders set exact points where their trades will terminate. This means that they can both accurately control what they are willing to lose, as well as step away from their platform for a moment if something else needs their immediate attention.
This isn’t only advice for using leverage. Take profits and stop losses are great tools to help greed and fear from controlling trades. However, they are particularly important for leveraged trades, since these tend to be larger positions.
Negative balance protection
A forex broker with negative balance protection is crucial for those who employ leverage. It has been said many times in this article that leverage can wipe out accounts quickly. The situation is even more dire if the account can go into the negative, and in that case, a bad decision can harm a trader’s finances significantly.
Negative balance protection prevents that, and essentially prevents traders from losing more than they own. It’s a fairly rudimentary practice that can prevent catastrophe. Luckily, most brokers offer negative balance protection, but it’s something traders who intend to use leverage should check.
Conclusion
Using forex leverage comes down to a solid trading routine and protecting yourself from adverse circumstances. Traders who complete these two steps could find leverage quite a useful tool that helps them better manage their capital and really hammer on trades that they believe in. Just remember, be meticulous when calculating your position and don’t overleverage.
Disclaimer: This information is not considered investment advice or an investment recommendation, but instead a marketing communication.
