The use of leverage is often an underrated topic amongst traders managing the risk that comes with trading a forex account. As a new month begins, it’s a good idea to look at how you can use just the right amount of leverage to ensure longevity and long term growth in your trading account. Just because the massive leverage is out there to use, doesn’t mean it needs to be maximized at all times.
Today’s guest post is courtesy of Cory Mitchell, a proprietary trader and Chartered Market Technician (CMT) specializing in short to medium-term technical strategies. He is the founder of VantagePointTrading.com, a website dedicated to trader education and market analysis.
After graduating with a business degree, Mitchell has been trading multiple markets and educating traders since 2005. He has been widely published and is a member of the Canadian Society of Technical Analysts and the Market Technicians Association. He’s the author of the Forex Strategies Guide for Day and Swing Traders – an eBook introducing traders to the basics of Forex, the formula for success and price action trading strategies.
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Cory Mitchell, CMT discussing leverage.
With some forex brokers offering up to 500: 1 leverage it is little wonder why “How much forex leverage to use?” is a common question, especially among new forex traders. Most traders realize that leverage is a double-edged sword, magnifying profits as well as losses. To understand how much forex leverage to use we will look at examples for different account sizes and trading styles. But first, we need to set some money management ground rules.
Money Management and Leverage
Only risk 1%, or less, of deposited capital on a given a trade. Risk is the difference between the entry price and the stop loss, multiplied by the size (lots) of the position. For instance, assume you buy the EURUSD at 1.30. You place a stop loss at 1.29, which is 100 pips lower than the entry price. In the EURUSD each pip is worth $10 on a standard lot (100,000 worth of currency), $1 for a mini lot (10,000), and $0.10 for a micro lot (1,000). Therefore, the risk of the trade for one standard lot is $1000 (100 pips X $10 per pip), $100 for a mini lot and $10 for a micro lot. If multiple lots are taken then the dollars at risk for one lot would be multiplied by the number of lots taken. If you are unclear on what pips are, and how they are valued, read Calculating Pip Value.
The dollar amount at risk should not exceed 1% of deposited capital. So in the case above, if taking a trade where the risk is $1000, the account size must be at least $100,000. If risking $100 per trade, the account size should be at least $10,000, and if risking $10 per trade, the account size should be at least $1000 (because $10 is 1% of $1000).
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 to Use – 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
Based on the account size of $10,000, the trader can risk $100/trade (1% of 10,000). If a trade develops which has a 300 pip risk (difference between entry and stop loss), the trader can take 3 micro lots, which results in a $90 risk. In this case, no leverage is needed. Taking a trade such as this means $3000 (3 micro lots) is deployed and the account more than covers such a transaction.
If a trade arises with a 75 pip stop loss, then you can still risk up to $100. In this case, you can take 1 mini lot ($75 at risk) and 3 mini lots ($22.5 at risk). If you take 1.3 mini lots total, your risk is $97.5, which is just below your $100 risk limit. 1.3 mini lots is $13,000 worth of currency though, and you only have $10,000 in your account, so you will need to use leverage. At least 2:1 is recommend in this case, as that will give you the ability the to trade 20,000 in currency (2 x your $10,000), which is more than enough to take this $13,000 position.
If multiple positions are taken at the same time you will need to utilize more leverage, such 5:1 or 10:1. Each trade could have a different stop loss, so it is better to have slightly more leverage than not enough. If you have extra leverage, you don’t need to use it.
If you are swing trading with a $1000 (approximately), check out Forex Swing Trading with $1,000 or Less for more details on successfully trading a small account.
$10,000 account – day trader
Since a pair like EURUSD usually moves between 90 and 130 pips a day, day traders will likely not be risking more than 10 to 20 pips on a trade. Losses on individual trades should still be kept to 1%, or less, of the account value. Taking a trade with 20 pips of risk means the trader can take 50 micro lots or 5 mini lots, which would equate to a risk of $100 in the EURUSD.
5 mini lots is $50,000 worth of currency, so some leverage is needed (only $10,000 in the account). Risk is being well controlled, so in this case leverage is a great advantage for this strategy. It is also quite possible that the trader may have multiple positions with similar risk. If the trader had 2 similar positions it would mean $150,000 is deployed in the market. Therefore, this trader would need a minimum of 15:1 leverage, but could even go up to 30:1 (allows the trader to deploy positions worth up to $300,000) or 50:1. Beyond that there is little use for more leverage.
The same scenarios can be repeated with a larger account or smaller accounts.
If you only have $1000 account and want to day trade, you will likely also want to use about 20 or 30:1 leverage. Everything is the same as above, except you will be risking $10 per trade and your position sizes will be 1/10 of those discussed above.
$5,000 account – scalper
Sticking to not risking more than 1% of deposited capital, this trader can risk up to $50/trade (1% of $5,000). Scalpers usually risk a small amount (in terms of pips) on each trade. Lets assume the trader risks 10 pips on a trade. That means in the EURUSD they can take 5 mini lots. If 10 pips is lost on 5 mini lots they have lost $50 or 1% of the account.
5 mini lots costs $50,000, so leverage 10:1 is required to take this trade. It is also possible that multiple trades may be in effect at one time. If three positions are held at a time, that means up to $150,000 in positions may be deployed. That requires at least a 30:1 leverage. For a bit of extra room use 50:1, but that is only if you are holding multiple positions at one time. If you typically take one trade at a time, then in a case like this, about 15 or 20:1 leverage is fine.
Why Do Brokers Provide Such Huge Leverage?
If you are wondering why forex 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 lot costs $1000, a mini lot $10,000 in a pair such as the EURUSD, so opening an account for less than $1000 means the trader needs leverage just to buy the smallest position size 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 big winners, but it rarely happens.
Summary – So how much forex leverage should you use?
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. You can have leverage on account, but don’t have to use it if it isn’t required. 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 enough. 20:1 is will suit most traders–day traders or swing traders–just fine. There are 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% of capital per trade, traders will find very little need for the astronomical leverage brokers provide.