Leverage? Do you WANT me to die?!?!?

Beginner Questions
1

Ok, I realize I’m new and don’t know anything about anything, but I just jumped waaaaaay ahead in the babypips school to the section on leverage and margin. A little horrified here. Seems to me if you have a large enough balance you don’t need it, and if you have a small balance, then you’re playing with napalm since the reason it’s small is probably because you’re new and think you can make millions off a $500 deposit.

Are there any successful, experienced traders who actually think leverage is a good idea? And would care to explain why?

Thanks. Gonna go get a cold compress now.

2

As an experienced and successful trader, yes, leverage is a great thing. Putting your trading capital effectively to use would be difficult without it.

There is nothing inherantly wrong with leverage. Leverage doesnt = risk, rather oversizing = risk. Leverage may make it easier to oversize, but traders have to have self discipline and choose to properly size their trades regardless of the leverage.

Leverage allows capital to be efficiently used. For example if I can take a trade and only use 10% of my capital, that leaves the other 90% to be put to use elsewhere. Regardless of a persons account size, without leverage it would be hard to make a decent % return in Forex, and would limit your opprtunity to put your trading capital to use in other trades.

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3

Thanks for the response. 2 questions.

  1. I realize calculating acceptable risk is a lot more complex than just a flat 1%, but that seems to be the baseline recommendation. So you’re saying you can use 10% of you’re capital to make a trade as long as you place your stop so that you only stand to lose that hypothetical 1% if the trade goes south? I know that’s not exactly a leverage question, but I wanted to ask. I guess I was thinking of risk management in terms of only using 1% of your account per trade.

  2. Correct me if I’m wrong, but I’m kinda thinking someone just starting to trade live should make use of leverage as little as possible until they’re consistently profitable.Correct? And as a follow up to that, can I operate a $5000 learning account effectively without the use of leverage? Should I?

4

Both are good questions. Your leverage should have no effect on how large of a position you take in your trade. If you decide you want to take 1% risk, leverage has no factor in that calculation. In a hypothetical, lets say you calculate that you need a 1 lot to have 1% risk for a specific trade. Your leverage will determine if that 1 lot uses all of your capital, half of your capital, or 1/10th of your capital, but at any level of leverage that trade will still require 1 lot for 1 % risk.

Now if your asking if 1% is a good number, my personal feeling is no. My trades are almost always 0.3 to 0.5% risk per trade. Traders want large returns by using huge risk, when they really should want high returns through winning trades. If you are terrible at trading then risking more isn’t going to help, and if you are good at trading then you won’t need to over-risk to make decent returns.

Again, you need to separate the idea of margin and risk. If a new trader is given 1:50 or 1:500 leverage, it shouldn’t matter. How you trade with a low amount of leverage, you should be trading the exact same with a higher amount of leverage, the only difference being you will have more available funds with a higher margin. Obviously a trader can over-risk and use all of that margin, but that’s not really a margin problem, that’s an undisciplined trader problem.

Leverage serves a couple purposes, one is to make more efficient use of your capital, like I previously mentioned. The second is important specifically to the Forex market, which is it allows you to trade a large enough size to generate a decent return. You will find currency moves at just fractions of a percent, so leverage allows you to trade a large enough position to generate decent returns. A really good move might be a 0.25% move in the currency basket, but with leverage you may be able to trade enough to make that 0.25% movement a 3% move in your account.

A $5000 trading account with 1:1 leverage is the same as a $500 account with a 10:1 leverage, or a $50 trading account with 100:1 leverage. In the latter two cases you have the same amount of buying power, but free up 90%(with 10:1) or 99%(with 100:1) of your capital to achieve the same buying power, which takes me back to the point of capital efficiency. I don’t think 1:1 makes sense for any sized account, whether you are trading with 1000 dollars or 1 million dollars. Especially in Forex where you need leverage to generate decently sized returns on your trades.

5

I agree with you, leverage is actually a great thing. Though many people say that it is like a double edged sword which is true, but it could also magnify our profits if it is used in an efficient way. So it totally depends on the trader how he/she utilize the leverage.

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6

yup! just remember to keep risk management in mind too!

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7

musicguy1967, you’ve gotten good answers from krugman25 and JonesCario.

But, I’m wondering whether it’s clear to you which type of leverage you are asking about. If you are not aware that there are two leverages at work in every trade, then we have identified the source of your confusion.

• Maximum allowable leverage – this is the most you are allowed to use. This is the leverage your broker advertises. Typically big numbers, like 50:1, 100:1, 500:1, even 1000:1.

In terms of maximum allowable leverage, the answer to your question is: The higher the maximum allowable leverage - the better. This is the leverage krugman was talking about, when he said that high leverage is a good thing.

• Actual leverage used in a particular trade – this is the modest leverage you actually use, as a prudent and disciplined trader. It is simply the notional value of your trade (prudently sized) divided by the balance in your account.

In terms of actual leverage used, the answer to your question is: Determine the size of your position based on Risk, and ignore leverage altogether, because it will take care of itself. This is the leverage JonesCario was talking about, when he said that leverage is a two-edged sword.

Let’s compare two identical trades in two different accounts, to illustrate the value of high maximum allowable leverage.

For this comparison, let’s use extreme values, in order to make a point. Let’s say that maximum allowable leverage in one account is 10:1, and in the other account it’s 1000:1.

Now let’s say that each account has a balance of $2,000 and no open trades. Our two traders (let’s call them Trader A and Trader B) enter identical one-mini-lot positions, each with a notional value of $10,000.

A simple calculation reveals that each trader is using actual leverage of 5:1 (that is, notional value ÷ account balance = 5). In other words, both of these trades are well below the leverage limits imposed by the brokers.

Trader A’s account, with maximum allowable leverge of 10:1, requires 10% margin on each trade. Trader B’s account, with maximum allowable leverage of 1000:1, requires 0.1% margin on each trade.

In other words, $1,000 of Trader A’s balance (that’s half his balance) is tied up in margin on this one trade, and is not available to be used by him for any purpose, for the duration of this trade. Trader B, on the other hand, has only $10 of his money tied up in margin, and is able to deploy most of his $2,000 balance in other productive ways. This is what krugman was referring to, when he talked about making efficient use of capital.

Both traders will have their margin amounts released back to them, when their trades are closed. But, for the duration of these trades, Trader A’s account is severely handicapped, compared to Trader B.

8

I guess I got nervous when Pipsology started talking about how much you could potentially lose on margin if the trade went just a few pips against you. But that was in examples of being over-leveraged. If you have good stop placement you’ll be OK. Like one example that had a 10,000 account that was margined up to 8,000. When you factor in the spread it would only take a 22 pip loss to precipitate a margin call.

9

@musicguy1967 Clint, krugman25 and JonesCario have explained it perfectly above…

Below is another adaptation that maybe easier for newer members (Not yet in Pipsology School) trying to understand the Leverage, Margin, Lot Size relationship…

A 10,000 account and just 22 pips takes you to 8000 margin, your Lot Size is way too big.

To explain this in a Financial way…

Margin is the equivalent of Collateral on a secured bank loan, if you don’t have enough cash or assets to cover it, the Bank (Your Broker) won’t give you the loan… So you have to have enough collateral (Margin) to even get the loan… also understand that once you payback the loan, the Bank (Broker) releases the collateral… Margin = Collateral.

Leverage is the formula to size the collateral (Margin) required… say your $5000 loan (Lot Size) is for a car… you have good credit history, the Bank will only want, say 10% ($500) collateral to cover their exposure on the loan, we’ll call this 1: 500 Leverage. (which leaves you with more of your own capital to utilise)… Leverage = Margin Formula

Say you have a bad credit history, the Bank will want more collateral (Margin)… say 50% ($2500) collateral to cover their exposure on the loan, we’ll call this 1: 50 Leverage. (which leaves you with less of your own capital to utilise)

The car loan ($5000) (Lot Size) remains unchanged… The loan interest (Spread / Commissions) remains unchanged by the Higher or Lower collateral (Margin).

So… the amount you loan (Lot Size) will have a direct bearing on how much collateral (Margin) will be rendered unavailable for the period (Time Trade is Open) of the loan. A more expensive car (Lot Size) will result in less funds available for other things, like food and rent… or in FX, more positions or ability to hedge…

Leverage be it 1: 1000 or 1: 30 has no impact on the size of your profit, the size of your loss while you are trading… only the amount of Margin (Collateral) that is unavailable while you have a position(s) open.

A 10,000 account that 22 pips takes you to 8000 margin, your Lot Size is dangerous. This is why lower Leverage will require you to apply smaller Lot Sizes that don’t tie up a larger percentage of your Margin and give the trade more room to breathe via larger SL & TP and decrease the risk or running out of Margin… (Margin Call)

ESMA has implemented the 1: 30 Leverage limit as a way of supposably removing access to lowly funded (at risk) retail traders from a loosely regulated market… While ensuring that Brokers have an even larger vault of funds and margin “collateral” should a Black Swan event occur in the future…Win…Win…Win…

Hope this helps anyone that is struggling with Leverage, Margin and the correlation of Lot Sizes.

10

Hello, I was just wondering on how did you calculate this part. Thank youu

11

Hello, totato.

In the example (in my previous post), Trader A’s metrics are as follows:

[U]Trader A[/U]

  • Account balance: $2,000
  • Maximum allowalbe leverage (account leverage limit): 10:1
  • Required initial margin: 10% of notional value
  • Position size: one-mini-lot
  • Notional value: $10,000

10% margin percentage x $10,000 notional value = $1,000 margin amount, which is one-half of Trader A’s balance. In other words, half of Trader A’s balance is set aside by the broker, and is not available for his use for any other purpose, for as long as this trade is open.

[U]Trader A has only the remaining half of his account available for[/U] –

  • for covering losses (should they occur) in this trade,
  • for use as margin on additional trades,
  • for covering losses in those additional trades, or
  • for withdrawal.

By contrast, Trader B, having the same size account, having 1000:1 account leverage, and entering the same trade, had only $10 set aside as initial margin (0.10% x $10,000 = $10).

Note that, for simplicity, I have ignored maintenance margin in this example. In case you are not up-to-speed on initial margin vs. maintenance margin, write back and I’ll run through it.

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