Learning Trade Forex

Leverage
Before you attempt any sort of trading you need to fully understand the risks involved. Besides the fact that trading platforms now offer smaller lots that enable almost anyone to trade. They also offer a high degree of leverage. Using leverage can make or break you as a trader.

Leveraging can best be described as a leverage ratio or margin percent, or the use of borrowed capital to improve the speculative capacity and rate of return from an investment. In layman's terms it means when using leverage of 100:1 we are borrowing $100 for every $1 of our own capital. Our margin is therefore 1% or we are geared at a ratio of 100:1.

Margin is the amount of collateral deposited with a broker when borrowing from that broker to trade currencies. We calculate leverage or gearing by dividing the capital into the lot size. Assume a maxi account of $10,000 trading 1 lot in the market with 100:1 leverage. The calculation would be as follows.

(100,000/10,000)= Gearing of 10%. Assume 2 lots in the market (200,000/10,000)= Gearing of 20% or exposing 20% of our capital on a single trade.

Assume we trade a mini account of $5000, trading 1 lot with 100:1 leverage. The calculation would be as follows.

Mini account (10,000/5000)= leverage of 2% being used. Assume the same account with 5lots in the market (50,000/5000) would mean exposing 10% of our capital on a single trade.

Gearing or leverage is vital to understand from the outset. It simply means the lower the gearing the lower the risk. If we examine the the above examples it is clear that if we opened a maxi account with $10,000 the minimum risk per trade would be 10% of our capital. By the same token risking 5 lots on the mini account of $5000 would be 10% of our capital. Risking 10% of our capital per trade would soon spell the end of our capital and probably our demise as traders.

The above examples are simplistic views of leverage use because we have not taken any stop loss values into consideration. Many platforms will offer very high gearing to entice you to enter more lots in the market to make more money on your trades. Be very careful of this because you will only be increasing your risk and the spread charge of your broker.

Without margining or leverage, Forex trading would be inaccessible to most people. Leverage is a double edged sword, we cannot trade without it and too much of it will increase our risk of failure. Only by understanding the effects of leverage and your brokers policy regarding margin can we utilise leverage to benefit our every day trading.

The question then is how much leverage should we use?
The flexibility offered by mini accounts(10k) Micro accounts (1K) makes it easier to control the risk per trade because we can operate within the minimum and maximum extremes of the chosen leverage. The risk should rather be calculated as a percentage of capital. Whilst opinions may differ on risk from trader to trader, a prudent risk would be 1 to 2% of capital per trade.

Again lets assume we trade EURUSD on a mini account of $ 5000 with Leverage of 100:1 and risk 2% of capital to make 100 Pips or $100 profit.

With leverage of 100:1 we can enter the market with a maximum of 50 lots (5000/100) but our strategy assumes a risk of 2% which is $100. (5000*.02). This means that if the market goes 100 pips against us we lose $100 or if it goes 100pips in our favour we make $100.

Therefore in order to meet the requirements of our risk strategy we could only enter the market with 1 lot. Had we entered the trade with 2 lots we would only be able to risk a 50 pip move against us to lose $100 or a 50 pip move in our favour to make $100. Likewise 3 lots = 33 pips against or for us.

It is clear therefore that the leverage and margin will in no way affect the profit or loss on the trade provided we have a predefined risk. The real risk of the trade is 2%, that is unless you trade without a stop loss and let the market run against you in which case you will be risking your capital 10 times.

The only difference between 100:1 leverage and 400:1 Leverage in the above example is the amount of margin required to do the trade. With 1 lot at 100:1 gearing the margin requirement is $100, at 400:1 the margin requirement is $25. Had we done the same trade with 400:1 gearing the end result would have been the same, the risk $100 and the profit $100.

Summary

• Leverage is the margin amount required and expressed as a ratio if all the borrowing capacity allowed by your broker is utilised.
• Real leverage is calculated by dividing your capital into the value of your open positions.
• Multiple trades and different currency pairs can increase the amount of real leverage used.
• Margin requirements have no influence on risk if traded with modest leverage.
• Do not be tempted by greed to risk more lots than your risk management strategy calls for.
• If you are not comfortable with the risk on a trade, regardless of how good the setup looks then rather give the trade a miss.
• Leverage is not what your broker allows you to use, it is what you decide to use as you can see in the following table based on our example above.