How Does Leverage Affect Forex Trading

In reality, when you trade currencies, you are in effect buy or selling one currency against the other. This means that in essence there are only two possibilities. Price will go up or price will go down. In theory it is a 50-50 call. Why is it then, that as higher percent as 95% of all forex traders lose money?

If there is one sure thing in this world it has to be that forex trading is much more difficult than it seems.

In reality, when you trade currencies, you are in effect buy or selling one currency against the other. This means that in essence there are only two possibilities. Price will go up or price will go down. In theory it is a 50-50 call.

Why is it then, that as higher percent as 95% of all forex traders lose money?

Perhaps it has something to do with the way price moves. You see price can only go up or down and that is a fact. But it can make long or short staccato movements. It may go up just a few pips and then down just a few. This should not really matter to the trader at first glance, but when you add in the fact that most traders, and especially those in the 95% category, are using very high levels of leverage, then those small movements in price are actually quite large from the traders’ perspective.

Understanding leverage is quite complex but here is a simplified view:

When you trade currencies in standard lots you are in fact contracting to buy or sell in multiples of $100,000 worth of currency. Each $100,000 is 1 regular or standard lot.

Because of the leveraged nature of retail trading, you will never need to put up $100,000 to finance the transaction because you will secure the transaction with a proportion of your money based upon how much leverage you are using.

Leverage is in essence the amount of money you are contracting to buy or sell verses the amount of money you are actually using to secure the transaction (margin).

For example, if you buy or sell 1 standard lot at leverage of 100:1 you are contracting to buy or sell $100,000 worth of currency but you are only using $1000 of margin to secure this transaction.

What this means in real trading terms is that the higher the leverage, the greater the return on a small movement of price in your favour but also the greater the risk should price move against you.

It is very usual for retail traders to use a leverage of 100:1 but as your account grows ($100,000 or more) a lower leverage would give you and your account greater protection.

On a standard lot trade of 1 lot at leverage of 100:1 for each price movement of 1 pip you would gain or lose $10.

At a leverage of 200:1 you would gain or lose $20 for each 1 pip change in price and so on.

This means that although on the winning side your profits grow much more quickly, your stop loss requirement (financially) would be twice as high – your risk is twice as high.

Some brokerages offer as much as 250 or even as high as 400 to 1 leverage, but my advice would be to never use leverage greater than 100:1. And to reduce that level as soon as possible.

Most professional account managers would never use leverage in excess of 20:1

If you are trading mini lots (0.1) then all of the figures above would be divided by 10.

If you are trading micro lots (0.01) then all of the figures above would be divided by 100.

So as you can clearly see, it is in some large part, the amount of leverage employed by the trader that makes trading more difficult. So why use leverage at all?

If you had at your disposal a vast amount of money that you were free to speculate with, such as is the case with some famous investors such as George Soros and Warren Buffet, then of course a great deal of money could be made or lost with a relative low element of risk by being what is known as a “real money” Investor. That is to say a trader that speculates on buying one currency against another without any leverage at all.

Unfortunately, the vast majority of traders do not have such deep pockets, and so the only way that they can trade the currency markets is by leveraging their money and taking on board increased risk.

Taking on more risk is to some extent acceptable strategy, so long as you both understand the nature of the risk, and so long as you have a money management strategy. If you end up taking the risk, without understanding that risk and making suitable preparations to manage that risk, then you are most likely to end up being one of the 95% of those traders who lose money.

To help you to trade more effectively, visit the website of the Stealth Forex Trading System™.