Trying to understand leverage and risk

Having a hard time understanding leverage. Well, I’ve mostly got it now I think, but if you agreed to risk only 1% of your capital. Would leverage then not matter because you’ve got a predetermined risk set?
The risk would remain the same right? And so using leverage would only magnify this risk and in turn this would disagree with your agreed risk you said you’d use. Right?
Also, not sure how stupid this sounds but heard people say 'don’t decrease leverage decrease lot size’
Isn’t leverage essentially lot size or have I got it all wrong?
Thanks for any help

Right (as long as you’ve worked it out correctly, in entering your position).

No; leverage represents the proportion of the value of each quantity of currency you trade that the broker is essentially lending you for the purpose of the transaction. If you have 1:100 leverage, you’re paying only 1% of the cost of opening a position of any specified size. If you buy one micro-lot of EUR/USD, that’s always worth the same $1,000, and its price-movements always represent the same $0.10 per pip to you, regardless of your leverage.

The two things are explained together, on one page, [B]here[/B].

Thanks a lot, just read that article again and it did clear things up. But I still can’t really see the use in leverage, just because I can’t get it in my head of what it’s used for. It lets you buy more currencies, but also increases losses, so why use it if you don’t wanna risk too much?
So if I had a 5000gbp account and was to risk only 1% on each trade. So £50 each trade maximum. But then if used leverage…? This would increase? So I just wouldn’t use leverage? Again thanks for any help, feel rather stupid though haha

If you wanted to buy even a [B][U]micro[/U][/B]lot of EUR/USD, without leverage you’d need $1,000 in your account. And given its $0.10-per-pip price movements, it would take you a very long time to have much profit to show from your successful trades. A 20-pip move in your favour would earn you only $2 on your $1,000 investment.

With 1:100 leverage, you can effectively buy that same microlot for $10 (because the broker temporarily lends you the other $990, in effect), but the price movements are still the same $0.10 per-pip. So the same 20-pip move in your favour earns you $2 on an investment of $10 instead. On a percentage basis, you’ve made 100 times as much profit.

Look at it this way, if it helps: when you buy a house for $300,000 and it goes up in value over a few years to $500,000 (“chance would be a fine thing”!), you’ve made a $200,000 profit on your $300,000 investment. That’s about 67%. But if you borrow $200,000 of the original $300,000 from a mortgage company, as long as you pay the interest on the loan, when you sell the house, you still get the $200,000 profit in your own pocket. You don’t also have to give the mortgage company two thirds of the profit because two thirds of the funds you bought the property with was their money. So you’ve made $200,000 by investing $100,000 of your own money, instead of making $200,000 by investing $300,000 of your own money. And that’s 200% profit instead of 67%. The principle is identical.

Does this make sense?

Tell me, if not, and I’ll try to explain it another way.

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I realize it’s easy to talk about leverage use in terms of lending and borrowing. It’s how a lot of people can understand it. The problem is it’s factually incorrect. Trading on leverage in the stock market works this way (the broker loans you the money to buy stock, for which you must pay interest). It does not work this way in retail forex, just as it doesn’t in futures.

Yes, I know, John - but it’s the way it’s almost universally explained, and it does arguably make it more understandable.

I always dress it up, when I explain it this way, as above for example, by throwing in the word “[I][U]effectively[/U][/I]” (to imply "ok, this isn’t [I][U]actually[/U][/I] what happens, but it’s a much more convenient way of illustrating the concept).

Absolutely no disrespect at all to the OP, of course, but explaining leverage to someone who presumably doesn’t yet fully appreciate the difference between a genuine broker and a counterparty market-maker is neither simple nor straightforward!


Yeah it definitely makes sense. Would you be able to possibly give an example of a trade? Can’t visualise it with the trade and everything… Say I’ve got a 5000gbp account, decide to trade 10 microlots so 10,000 units right? How would this work and once I’ve determined my stop based on market structure or whatever how would I ensure it fits within my risk management. Again sorry this is the only thing that confused me in the babypips school but obviously need to understand it. Thanks!

I can try …

Ok, so you have a £5,000 account, and let’s say (for the sake of this example) that you’re trading EUR/USD (always round numbers, there, in US$, so it’s a convenient example). And let’s further assume that you’ve worked out that you want to expose to risk no more than 1% of your account on any individual trade - generally a good starting point, for many people.

So, you’re looking at EUR/USD and along comes your set-up, and you want to enter a trade. Let’s say a long trade: you think the Euro will strengthen against the dollar/the dollar will weaken against the Euro. You think the EUR/USD price will rise.

You want to risk no more than £50 of your account on this trade (being 1% of £5,000), so you want the distance from your entry-point to the stop-loss - if it all goes pear-shaped on you - to represent no more than £50 damage.

Let’s say that for whatever reason you decide this trade needs a stop-loss of 25 pips. That means that if the price moves 25 pips against you, you’ve decided (at the time of placing the trade) that it wasn’t a good entry after all, and you no longer want to be in the trade. So you want 25 pips to represent £50 (which means $65.67, at today’s exchange-rate), and that comes to $2.62 per pip. A minilot (10 microlots) of EUR/USD works out at $1 per pip, so you can afford to trade 2.62 minilots (26.2 microlots). This is just arithmetic: a minilot’s movements win/lose you $1 per pip (always - regardless of leverage), so with a 25-pip stop-loss, if it all goes wrong and your trade is stopped out, a one-minilot trade would cost you $25: you’re actually willing to risk $65.67, so that’s going to represent 2.62 minilots (65.67 divided by 25).

You might later move the stop-loss [I]during[/I] the trade, to [U]reduce[/U] risk or to lock in some profit (we hope), but you won’t ever move it away from the original price, increasing your risk to more than 1% - kind of a “golden rule”, there - because you’ve already decided on opening the trade that a 25-pip loss will take you out of it, and you stick to that.

So you’re going to buy 2.62 minilots of EUR/USD, knowing that you’re selling it again, if you have to (i.e. if you get stopped out) after a 25-pip loss.

Note that so far, your leverage has [U]not[/U] affected anything we’ve mentioned.

One lot of EUR/USD costs $100,000 to buy (always - by definition), so 2.62 minilots of EUR/USD therefore costs $26,200. And that’s where leverage comes in, because you’re (“effectively, kind of”) borrowing 99% of the money temporarily, to buy it (if you use 1:100 leverage) so you need only a theoretical $262 in your account to buy those 2.62 minilots (I say “theoretical” because in reality your broker will require you to have a bit more than just $262, to cover the risk of unforeseen accidents, but with sensible 1% risk-exposures that doesn’t matter to you, anyway). Your $262 is [I][U]not[/U][/I] all at risk, provided you enter a 25-pip stop-loss with the trade: only $65.67 of it (£50 of it) is at risk. Note that this depends on your stop-loss being acted on by your broker, which can occasionally be a problem for people “trading the news”. But we’re assuming for the moment that you’re not trading at 1.25pm UK time on the Friday that the US non-farm payrolls figure is about to be announced and that there are no “special/unusual risks” in trading whenever you’re trading.

A cumbersome explanation, I know.

Alternatively, you can call your account $6,567 rather than £5,000 in the first place, and work the whole thing out in dollars from the start. (That works neatly when you’re trading EUR/USD, not so conveniently when you’re trading CHF/JPY!).

There’s a free position-size calculator that you can use, here: [B]Position Size Calculator: Free Online Forex Position Sizing Calculator[/B] (note that leverage [I][U]isn’t[/U][/I] one of its required inputs).

Does that actually help, or have I made it more confusing??? :8:

No, like before, that definitely cleared things up. So does this mean though that leverage doesn’t really have much to do with deciding what lots to use? And really, though it does magnify losses and increase profits, this is no problem because it’s just as if you have a bigger account? Thanks so much for the explanation, definitely helped.

This is no problem [B]if you work out position-sizing sensibly and don’t take ridiculous risks[/B] because it’s just as if you have a bigger account, I think.

It’s not the very high leverage [I]in itself[/I] that’s typically the problem for people using very high leverage, it seems to me. It’s more the people who use it, and all the other things they do wrong! That’s just my perspective, of course … :33:

I don’t know: I don’t understand enough about how people relate to leverage to understand how many lots they decide to use.

What I [I][U]do[/U][/I] know (from “forum experience” and quite a bit of it, now) is that in practice, the group of “people who are instinctively drawn to very high leverage” and the group of “people who use greatly excess position-sizes” overlap [U]very[/U] substantially.

There’s a very simple reason for this, in my opinion, and one of which I feel confident (though I won’t pretend to be able to “prove” it): they’re people who instinctively look at trading - and particularly [I]forex[/I]-trading - in terms of profit maximisation rather than in terms of risk management. And in the long run, their eventual overlap with the group of “people who end up making a living through trading” is really infinitessimally small (simply because any kind of long-term successful financial trading [U][B]is[/B][/U] about understanding risk management, and there isn’t a way of changing that!).

The problem with risk management is that it’s pretty counter-intuitive, to most people, and that makes it hard to learn - and something that’s hard to learn is never likely to become [I]most people’s[/I] instinctive perspective. (A trivial example: most aspiring traders with a system to trade and one for which they want to work out appropriate position-sizing imagine that their “longest foreseeable losing run” is what they should primarily be concerned with, but it just [U]isn’t[/U]. This, however, is much easier to assert than it is to prove or explain.)

I can’t remember whether I’ve mentioned these to you before, but I have three different levels of “book recommendations” on position-sizing, roughly in accordance with people’s existing knowledge/experience levels …

[U]Lowest level[/U]: [I]Trade Your Way to Financial Freedom[/I] by Van K. Tharp (especially the second half of the book - very useful to read [I][U]before[/U][/I] trying trading on demo - a downloadable PDF copy of this one is floating around online, I’m told);

[U]Slightly higher level[/U]: [I]Profitability & Systematic Trading[/I] by Michael Harris (Wiley, 2007 - I’d advise nobody to trade with real money until they’ve read this one - also available in PDF form, I think);

[U]Slightly higher level again[/U]: [I]The Mathematics of Money Management: Risk Analysis Techniques for Traders[/I] by Ralph Vince (there are one or two people here, admittedly, to whom I’ve recommended this excellent book, who have found it slightly “hard going”, so although I think it’s actually the best book of the three, I also know that it’s probably not for everyone).

None of three books listed above is specific to [I]forex[/I] trading - but that isn’t relevant at all.

Thank you, I’ll check out the books, appreciate all the help!

Let me give you an example:

Suppose, we are trading with $100,000(1 standard lot) position with 1:1 leverage (which means you invested the entire cost of the position yourself and had no borrowings) has now risen in value to $102,000. This means you have made a $2000 profit and your rate of return would be a mere 2% ($2000 profit divided by $100,000 money you invested as deposit)

But, what would happen if you had a leverage of 100:1 and the $100,000 had risen to $102,000? In that case you would have invested only $1000 of your own money and the remaining $99,000 would have come as a loan from your broker. But importantly your rate of return has increased manifold, and in this instance would be 200% (divide $2000 profit by $ 1000 initial deposit and multiply that figure by 100).

From the above examples we can see that: a 1:1 leverage got you a mere 2% rate of return while a 100:1 leverage got you a 200% return.

Thanks for this!

Don’t forget to explaint that if it moves the other way he blows his entire account, not just a “mere” 2%

Hi Carlos,

sorry if my english not clear enough

please , Do Elaborate me about the risk of using higher leverage , i agree with your last post , i have read a post from lexys and kizir007 , they did explain clearly about how leverage increase profit from larger margin . Buy still i want to know what about a losing open trade ? is losing trade double the lose because of higher leverage ?

For example :
let’s say we put in this 2 condition of open trade :

  1. Leverage 1:1 , margin $1000 , i plan to risk only 1% of total margin , which is $10 , i always open trade with $10 or less as my stop loss , so i wont lose more then $10 (1%) .

  2. Leverage 1:100 , $1000 margin will turn into $100.000 , i plan to risk only 1% of total margin , which is $1000 or less as my stop loss , so i wont lose more then $1000 ( 1% ) .

Question :

  1. is my logic about 2nd condition right ?
  2. is my stop loss still count as losing $1000 or it will be more because of higher leverage ?

I have read many people write about never use leverage , but i never really get what they mean , i just want to know how it effect our stop loss ? how leverage will get you margin call if we always use 1% stop loss ?

thanks for anyone help

No risking 1% of margin is your actual margin regardless of leverage used. So in both cases above you stop loss would be $10. By increasing leverage you increase your pip value. Thus the higher the leverage used the higher the pip value so the tighter the stop will have to be in order to keep within the 1% ($10).

Hi Bobmaninc,

thanks for your confirmation .

now i understand how leverage effect my margin , and then how margin will effect my lot and then further effect my risk management .

glad i’m jumping into this thread to clear this one out