I’ve been demo trading for a few months, and now I’m live trading with Micro lots to get a feel for using real money… but one thing I never got my head around was leverage.
I know too much leverage is bad because it not only enhances your potential profits, but also your losses.
But if we are always risking a certain amount of our account on each trade (lets say 3%) then why does leverage matter??
If I have a balance of $10,000 and I trade a mini account. I want to take a trade on the GBP/USD. So each pip movement is worth -/+ $1. My stop loss is positioned 100 pips from my entry (100 pips risk) so I will be able to open a position with 3 mini lots. 3 mini lots x 100 pips = $300 = 3% of my account.
So what does it matter if I have 400:1, 200:1, 100:1, or 50:1 leverage??? No matter what my leverage is it will still take a movement of 100 pips to stop me out and I will loose 3% of my account. I don’t understand how leverage will affect my profits/loss?
I typed a reply the other day but it never appear… weird… anyway here it is again.
Thanks for the help Clint.
I now get the idea that if Maximum Leverage is more than Actual leverage, I don’t have to worry about it.
Using the example above if my broker only offered a Maximum leverage of 2:1 (not likely but just an example) I couldn’t put on my trade because my Maximum Leverage (2:1) would be less than my Actual leverage (3:1), and if the trade went against me I would get a margin call before my stop was hit. Therefore if I had a larger maximum Leverage (100:1) than my Actual Leverage (3:1) I wouldn’t have to worry about a margin call.
So I get that now… but why then do they say leverage is the number 1 killer of newbies in forex? Is it because new people don’t limit their risk?
Also I’m not too sure what you mean by “Actual leverage used is not proportional to risk taken, contrary to what some people think.”. Could you please explain this a little more?
Basically correct, except that such a trade could never “go against you”, because such a trade could never be placed. Here’s why: Margin is the flip-side of allowable leverage. With 2:1 allowable leverage, the margin required by your broker would be 50% of the notional value (position size) of your trade. So, for a $30,000 position size, your broker would demand $15,000 in margin — more money than you have in your account.
Exactly. If your broker offers you 100:1 leverage, and you take that to mean that you can place trades which are 100 times the actual size of your account, then you will be in very big trouble, very quickly.
On the other hand, if you set a sensible limit on the amount of risk you are willing to take on each trade, and stick to your limit, then the leverage you actually use will take care of itself, as the following answer will demonstrate.
Here are examples of 4 trades with the same risk, but different actual leverage. I’m using the same account size ($10,000 mini-account) and risk percentage (3% risk on each trade) that you used in your example. Using these numbers, your risk on each trade will be $300 (or less).
Suppose you are trading the GBP/USD, which has a pip value of $1 per pip per mini-lot. And suppose that the 4 trades in this example have stop-losses as follows: 20, 30, 40, and 50 pips, respectively.
For each trade, you calculate the maximum number of mini-lots that you can trade without exceeding your predetermined risk limit of 3%. You make this calculation either by hand using the Position Size formula, or by using the Babypips Position Size Calculator in the Tools section of this website.
Here are the metrics for each of these 4 trades:
[B]1.[/B] For the trade with the 20-pip stop-loss, you may trade 15 mini-lots = $150,000 position size.
Risk = $300. Actual leverage used = 15:1
[B]2.[/B] For the trade with the 30-pip stop-loss, you may trade 10 mini-lots = $100,000 position size.
Risk = $300. Actual leverage used = 10:1
[B]3.[/B] For the trade with the 40-pip stop-loss, you may trade 7 mini-lots = $70,000 position size.
Risk = $280. Actual leverage used = 7:1
[B]4.[/B] For the trade with the 50-pip stop-loss, you may trade 6 mini-lots = $60,000 position size.
Risk = $300. Actual leverage used = 6:1
You should be able to confirm for yourself that the position size, the amount risked, and the actual leverage used is correct for each of these trades.
Notice that RISK (3% = $300) is the same (or nearly the same) for these 4 trades, but the actual leverage used varies from 15:1 down to 6:1.
That’s why I said that actual leverage used is not proportional to risk.
Leverage becomes a detriment when you max out lot sizes.
If you had a $3,000 account, you could buy a full size $100k lot of euro.
The pips would be $10.00 a piece, and if price moved 20 pips, you would lose 5% or so of your account, and get a margin call.
You would have your $2,800 margin still left, but taking hits like that, it wouldn’t last long.
Now a little different spin on the same overleveraged situation would be a 3k account in which you leveraged the same 100k by getting into 10 different trades of 10k each.
This is a much more dangerous situation that the first one.
If price moved the first 20 pips against you, one trade would close. $280 in margin would be freed up, but at the $9 a pip left, all it would take is another 31 pip move against you, and you would get hit again with a margin call. Another $280 would be freed up, but at $8 a pip, it would only take another 35 pip move against you to get hit with another trade closure. Another $280 gets freed up, but price still moves against you. 40 pips later, you get another margin call.
That’s a cumulative 126 pip move that just wiped out a full third of your account, and all you were doing was trading mini lots.
wow really brilliant explanations here. I thought i had the basics of leverage and risk down but this really does help clarify things. Really good job Clint & Master Tang