Leverage! The experienced traders best friend and the inexperienced traders worse enemy!
Hi everyone,
Leverage! This complicated word that so many can’t understand and so many miss use.
What does it mean then?? When a broker offers you a 400 Leverage, this means that the broker offers you 400 times more liquidity then you have on your account. It does not mean that you trade risky or gamble. It means that you can do if you are willing to.
Lets use an example. You have a 10.000$ account with 400 leverage. This means you can open up to 4.000.000$ in positions. This would be a 40 lot position on any USD/XXX pair.
Let’s use eur/usd, the most traded pair and not consider any spreads, swaps or commissions. 1 lot represents 100.000units. Now you place a 10 lot at 1.0600, meaning you are investing 10 x 100.000 x 1.0600 = 1.060.000 dollars in the euro.
The currency rate now drops 20 pips to 1.0580. Your 10 lot position is now worth 10 x 100.000 x 1.0580 = 1.058.000 dollars and your 10k account has a open loss of 2.000$ with a 20% Draw down. If for any crazy reason the eur/usd would drop to 0.5000 your position would cause a loss of 10 x 100.000 x (1.0600–0.5000) = 560.000$.
All brokers to avoid such a loss on their own do impose margin requirements on all their clients. If your account equity drops to a level where it can no longer sustain the losses, your position will be automatically closed by the broker and you got stopped out. This is the basic concept of CFD (Contract for difference). You are allowed to trade with more capital then you have, but you need to be able to afford the difference in case of loss.
On my initial months of trading and testing different strategies and styles I realized that each time I increased my leverage, it affected my emotions. The account equity gets highly volatile with big moves causing high levels of stress. Having orders (Stop loss or hedges) too close most of times did stop me out as I was not comfortable enough to risk my investment. How did I get rid of my emotions? Very easy! Reducing my risk!
On all my current accounts my leverage goes from below 1 up to 2–5 at most and you can still achieve a profitability around 30–60% per year. Stop trying to make all profits in one day, you have 260 trading days in a year to distribute your risk.
Before mastering trading with leverage you have to master trading without leverage! Makes sense right?!
How do you calculate your current leverage then? We reverse engineer our current exposure.
Lets use the following example. You have 5.000$ equity on your account and have a 0.10 lot usd/jpy position at 114.40 and a 0.15 lot eur/usd position at 1.0550.
— usd/jpy you would be buying or selling dollars with a yen account, but as you have a dollar account, you need to multiply by the corresponded jpy/usd rate. 0.10 lot = 0.10 x 100.000units x 114.40 x 1/114.40 = 10.000$
— eur/usd you are buying or selling euros with a dollar account and need to use the currency rate to convert into invested dollars. 0.15 lot = 0.15 x 100.000units x 1.0550 = 15.825$
Your total used liquidity is 10.000$+15.825$=25.825$
With your equity at 5.000$, you are using a leverage of 25.825/5.000=5,165, a little above 5 times your account size.
Get rid of emotions, specially greed! If you wake up and feel you need to make 1.000$, STOP!! Go back to sleep and keep dreaming about it. You will just be looking at the charts and seeing opportunities where they don’t exist and you will of course want to make it with a fast small move, 20pips! That is easy right, odds are better than in the casino, its only 50/50 up or down.
You open a 5 lot eur/usd position and place your TP at 20pips where you will cash in those nice 1.000$. But as soon you open the position it goes 2–3 pips down due to spreads, that is already 100–150$ in red.
Did you checked the economic calendar? the time of trading? which session was starting or ending? What was your plan before you started? Rates go 10 pips down and you are around 600$ in loss. You always heard about patient and everything that goes down has to go up right? Rates keep dropping and go to 30 pips down and your loss is at 1.600$ now and your 5k account with 3.400$ equity. I am sure by now you are going through a rollercoaster of emotions and freaking out but you might think, “well I am sure if I close now it will go up immediately after and I will lose 1.6k, let’s be patient and see”. Another 30 pip drop and your position is now 60 pips in red and your account equity stands at 1.900$. You started the day aiming for 1k profit but somehow managed to lose more than half your account. At some point you will freak out and close your trade if it keeps going lower or exit after a small retracement up.
What went wrong here? 5 lot on eurusd is more then 500.000$ invested with a 5k account. Making the maths you where trading over 100 leverage.
Use the right amount of leverage that your are able to handle and manage and always trade with a plan. Make consistent profits, stop chasing big fat winnings with one trade. Use leverage with strong risk controls in your advantage and not against you risking bankrupting your account.
A good trader can trade through losses and can turn a loss into a gain, or breakeven. It takes substantial market experience and know-how. Pursuing a career in trading is in the reach of anyone. But do not mistake your lucky strikes in a bull market with brains and know-how. To succeed, it must be more than a hobby, and you have to put in the HARD WORK to make it happen. Until then you most probably will lose a substantial sum of money before you turn successful.
Welcome to the real world.
