Leverage, is it a friend or an enemy?
I get a lot of questions about leverage, but even more than that; I get a lot of questions from people blowing up their accounts that don’t even realize it’s because of leverage.
So I want to uncover up a few things about leverage. By this I hope at the very least makes you more aware about it and how it can be used. Then you have the opportunity of at least try to move a little bit more careful with it.
Trading with Leverage
New traders seem to consider leverage as really exciting or on the other hand as really terrifying.
So, what is the right approach about it?
I think it’s sort of like at a more caged animal. Like, Fair enough you can enjoy its benefits to it. But you have to respect it, if you don’t appreciate it, that’s when problems happen.
Before we get to the whys and the why not’s, let’s ask what is a fundamental question, before all of that:
What the bloody hell is leverage?
Now, some of you already are aware that leverage isn’t something that is solely used as a term in trading. It’s also for investments, and it’s also for business and financing general.
When it comes to the industry of finance, your leverage ratio is one of the most critical rates to use when you’re doing balance sheet analysis. It’s also known as you’re gearing ratio and it’s showing you the ratio of their capsule to equity capital.
And for trading, this is quite similar except in trading terms your leverage ratio is showing you the maximum that you can use rather than what you already have used.
So, for example, if your account has a leverage ratio of 100:1, it means that every single one dollar that you have in your account has a good value of a hundred dollars. Your one dollar is worth a hundred dollars, and the amount of leverage available in the account will depend on the broker and what they offer you. I will write about that in a few lines more.
All this writing will be about Forex, and all of our examples are going to be using for Forex.
The same is also mainly right for other asset classes as well, and if anything I write here confuses you then leave a comment below, and I will answer all your questions. It’s not a concept that everyone understands right from the beginning, so ask away, and I’ll explain the issues for you.
Forex is the best asset class to explain leverage with because in global Forex is offering the highest amount of leverage and just by default we trade in large amounts of Forex.
Let me explain, so with Forex trading, currency trading, we usually trade in currency pairs, and this is generally noticed as the base currency first followed by the quote currency.
One example, with EUR/USD Euro, is the base currency and the quote currency is USD, and when we trade these currency pairs is always in a lot of the base currency.
One standard lot will typically be a hundred thousand units of the base currency. A micro-lot will be 10,000 units of the base currency. So for example with EUR/USD where I just said Euro is the base currency, a standard lot will be a hundred thousand Euros.
Most private traders won’t have a hundred thousand Euros to spare to open a trade, and that’s why the leverage comes in handy.
So for example, if you’re being offered a 100:1 leverage, it
means that you can open a Standard Lot, not by having to put aside a hundred thousand Euros, but just by having to set aside 1000 Euros, which is one percent 100:1.
Unfortunately, in the US the maximum leverage you can have on a Forex account is 50:1. But outside the US, the rest of the world, you can have unlimited leverage.
The standard or typical amount for most brokers will be a 100:1 or 200:1 account.
These accounts that allow you to use leverage with your trading are called margin because the amount of money that you have to put aside is called margin.
Margin can be considered as the deposit that you have to put down for the trade.
For example in a 100:1 account you need to put down one percent as margin. So if one Standard Lot is a 100.000 units of the currency and you have a 100:1 account, meaning that you have to put down 1% as margin, that says you’re going to have to pursue aside 1000 units of that currency and it will be taken automatically by your broker and put aside for you.
While your trade is open, then that amount of money set aside as margin will be unavailable for you to trade.
It might still show on your principal balance, but in your available
balance your available amount of money in your account, it won’t be there is not going to be available, but as soon as you close that trade, it will instantly be available again.
So it’s not permanently taken off you, is no fee, it’s just a deposit that gets refunded when the trade is closed.
Hold your horses, because there are specific rules about that margin as well.
So, for example, most brokers typically will say that if your trade goes into a loss and it starts to exceed your margin by 10%, then they automatically close your trades at Lost. But before that happens, once your trade does start eating into a margin, your broker will usually phone you and ask you to deposit some more money into the account, and this is called a margin call.
So for example, let’s say you have a 100:1 leverage account and you want to open a trade that is one Standard Lot on USD/YPJ, this means that you’re going to have to put aside $1,000.
Let’s say that in your account your total balance is $2,000, and this means that you have $1,000 as margin and $1,000 left available to trade.
Now, if that trade moves against you as a loss by over a hundred points and you start to exceed 1000 dollars worth of lost on that open position, then your margin is going to start to get eaten into it.
At this point, your broker’s will start to call you and ask you to deposit more money and if it keeps going into more of a lost, and it exceeds 10% of that margin, its that $1,000 that was set aside, that means your lost is $1100. Then your trade could get closed out, and you’re accountable that we left as $900 or whatever is left of that margin.
Then leverage could be dangerous.
Imagine this, imagine American Express gives you a credit card that has a $10.000 limit, and your salary is $3.000 a month, before tax. So on average, the maximum that you spend each month for luxury goods is $5.000, that means, that credit card usually to be able to spend within your means, you’ll be spending $5.000 each month, around there or that amount as a maximum.
However, if you took that cars and one month decided to spend the whole $10,000, then you’re not spending within your means, and that means that you’re going to get yourself in some financial problems.
And it’s the same with leverage. Just because you have this big limit available to you, just because you can open these big position sizes relative to your account size, doesn’t mean you should, you should still always trade within your means.
And that is of course only of risking 1% or 2% of your account balance on any single trade, and when I say account balance, I mean your actual capital account balance.
Not your capital with leverage applied.
So it’s 1% or 2% of the actual money you own in the account, and if you can stick to that, then leverage will never be a problem for you.
Now let me anticipate some questions that I usually get for quite a few people because I’ve seen them in my email inbox.
So lets clear them right now.
Firstly people always ask me:
How do I know when the leverage being applied to my trade?
Well, the answer is, if you have a Forex account which has leverage applied to the account, which is most Forex account these days. Then every trade is going to have that leverage applied to it, but mainly the leverage does not need to be defined by how much margin you have to put aside for each trade.
If you’re intent on not using the leverage at all, then only ever open positions that represent the amount of money you have in your account.
So for example, if your account size is $10,000 only if I open one mini lot per trade.
Secondly, a lot of people come to and ask:
Well, can I open like a considerable position size then?
“I just set my stop loss closer because I can use leverage to open a massive size and just have a stop loss of one or two pips.”
Yes, you can do that, you can have a massive position size and still only be risking 1% to 2% of your account, just because your stop loss is only a few pips away from your entry.
But if you do that, also means you’re an idiot. I suggest you have to be bloody stupid to open position size that is a just disproportionately tremendous amount of capital you have in your account.
You’ve got to be masochistic to do that. You’ve got to want to wipe out your account if you’re risking 1% to 2% of it on a few pips, that means if you get negative slippage of a few pips, which often happens with stop losses, it’s like risking 5% or maybe even 10% and what if there’s a spike, you wipe out half your account.
Just think if you use the maximum 100:1 leverage it’s only going to take like a hundred points to wipe out your account, don’t do it.
And by the way, just before I finish this writing, if you’re taking your leverage return, the return that you made using leverage and comparing that to the market and claiming that you beat the market, right? Just don’t do it.
You got to strip out the leverage first of your account and what your actual return is, relative to the market.
This is why the Sharpe Ratio is such a great tool to use when you’re assessing fund managers in that forms. Because it can often be misleading if I say, for example, I made 20% return this year, and it’s from using leverage to count, compared to some of my 10% on an unleveraged account.
Be aware of those brokers that are offering ridiculously high leverage just trying to separate people from their money, and they are good at that. If you want to lose some money go for the high leverage