How Much Forex Leverage?
|March 29, 2012||Posted by Cory Mitchell, CMT under Intro to Trading, Techncial Analysis Tutorials|
How Much Forex Leverage?
Cory Mitchell, CMT
With some forex brokers offering up to 500: 1 leverage it is little wonder why “How much forex leverage?” is a common question especially among new (and seasoned) forex traders.
Most traders realize that leverage is a double-edged sword, magnifying profits as well as losses. To answer the question “How much forex leverage?” we will look at examples for different account sizes and trading styles. But first, we need to set some money management ground rules.
It is first important to note that only 1%, or less, of deposited capital should be risked on a given a trade. Risk is the difference between the entry price and the stop, multiplied by the size (lots) of the position. For instance let’s say you take a a long trade at 1.30 in the EUR/USD. You place a stop at 1.29, which is 100 pips lower than the entry price. In the EUR/USD each pip is $10 for trading a standard lot, $1 for a mini lot, and $0.10 for a micro lot. Therefore, the risk of the trade for one standard lot is $1000, $100 for a mini lot and $10 for a micro lot. If multiple lots are taken then the dollar risk for one lot would be multiplied by the number of lots taken.
The dollar amount at risk should not exceed 1% of deposited capital. Some traders use up to 5% but do so at your own risk and long-term potential peril. There is always opportunities to take profits and re-enter or to add to a position as it moves favorably (adding as it shows us a profit which allows us to move stop as new entries are made, not increase our original risk). For more on “pyramiding” you can see my Investopedia article: Pyramid Your Way to Profits
With some management guidelines under our belt, we can begin to consider how much leverage we should use/need for our account size and trading style.
How Much Forex Leverage – Scenarios
The easiest way to discuss leverage is to look at some examples of how much leverage is needed based on different combinations of account size and trading style. Let’s look at some examples:
$10,000 account – swing trader
If swing trading, stops are likely to be bigger than a day trader’s stops (as well as profit targets) so this needs to be accounted for. Based on the account size the trader can risk $100/trade (1% of 10,000). If a trade develops which has a 300 pip risk the trader can take 3 micro lots, which results in a $90 risk. In this case really no leverage is needed. Taking a trade such as this means $3000 is deployed and the account more than covers such a transaction.
If multiple positions are taken at the same time the trader may wish to have some leverage, such 5:1 or 10:1.
$10,000 account – day trader
Since a pair like EUR/USD usually moves between 100 and 150 pips a day, day traders will likely not be risking than 30 to 50 pips on a trade. Losses on individual trades should still be kept to 1% of account size or below. This means that a 25 pip risk on a trade means the trader can take 40 micro lots or 4 mini lots, which would equate to a risk of $100 in the EUR/USD.
4 mini lots is $40,000, so some leverage is needed obviously. Risk is being well controlled so in this case leverage is a great asset to this strategy. It is also quite possible that the trader may have multiple positions with similar risk. If the trader had 5 similar positions it would mean $200,000 deployed in the market (some of these may hedge each other, but assume they all move independently). Therefore, this trader would need a minimum of 20:1 leverage but could probably go up to 50:1. Beyond that there is little use for more leverage.
The same scenarios can be repeated with a larger account or smaller accounts.
Very high leverage is not required for most traders. The only traders who may require higher leverage are scalpers.
$50,000 account – scalper
Sticking to not risking more than 1% of deposited capital this trader can risk up to $500/trade. Scalpers usually risk a small amount (in terms of pips) on each trade. Lets assume the trader only risks 10 pips on a trade. That means in the EURUSD they can take 50 mini lots or 5 standard lot. If 10 pips is lost on 5 standard lots they have lost $500 or 1% of the account.
5 standard lots costs $500,000 so again leverage is required to trade this way. It is also quite possible again that multiple may be in effect at one time, especially when a program or expert adviser is in use. If up to five positions are held at a time that means up to $2,500,000 in positions may be deployed. That required at least a 50:1 leverage. For a bit of extra room more leverage can be added but even 100:1 is overkill.
Based on these examples, when risking a maximum of 1% of the account on a trade, and have multiple positions out at the same time there is likely little need to be over 50:1 leverage…and even that is highly unlikely.
It is also very important to note that events occur and liquidity can dry up, making positions impossible to liquidate at the stop price and exposing the trading to more risk than anticipated. In such situations using high leverage, even if a strategy calls for it, can seriously hurt an account. Use as much leverage is needed to trade a risk controlled style, but if positions end up being many many times the value of the deposit, it highly likely the account is being traded too aggressively.
Why Do Brokers Provide Such Huge Leverage?
If you are wondering why brokers offer leverage of up to 500:1 the answer is simple. It entices traders to invest $100 (or so) and try to gamble their way to profits. A micro lots costs $1000 a mini lot $10,000 in a pair such as the EUR/USD, so opening an account for less than $1000 means the trader needs leverage just to buy the smallest increment available. And since most new traders come to forex market with illusions or grandeur it is likely they will risk far more than 1% of their account, and leverage provides a way to do that. Insanely high leverage allows people to swing for the fences in the hopes of a hitting a couple winners, but it rarely happens.
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Summary – So how much forex leverage?
Using the examples above you can calculate how much leverage is needed for your account size and usual trading style. Many traders may find they actually don’t even need leverage, but having some is fine if multiple positions end up accumulating. There are always more trades, so there is little need to pile into one trade, risking a lot or needing excessive leverage. For most traders out there 50:1 leverage is way more than needed. There significant risks in forex trading, and using excessive leverage can mean not only taking a large loss, but wiping out the entire account. By risking 1% or 2% of capital per trade traders will find very little need for the astronomical leverage brokers provide.
Pip values vary by currency pair, so understanding how much a pip is worth in the currency pair being traded is an important step in making sure the proper position size is taken relative to account size.
Cory Mitchell, CMT