Who doesn’t want to make money fast? We all do. But there’s a fine line between trading… and risky gambling.
Risky gambling has as much to do with taking poor bets in bad trades as it does with the way you manage your risk and your capital.
So today, I want to let you in on one of the most important aspects of trading – and specifically forex trading…
What is leverage, and how can we use it safely and responsibly in our trading? I’ll show you below.
Now, fair warning: I can’t tell you what the “right” level of leverage is. It all comes down to each person’s risk tolerance. But I can give you some general guidelines…
A “Power Tool” for Forex Traders
One of the most interesting aspects of the forex (or currency) markets is the high degree of leverage that brokers can offer.
Now, Andy and I come from the more institutional, or professional, side of trading. In that side of trading, we use leverage… but we use it judiciously, and we respect it.
What I found on the retail side of trading is that there’s far more of a tendency to find brokers that offer ridiculously high amounts of leverage…
And a tendency for traders to take massively outsized bets in the hopes of doubling – or even tripling or quadrupling – a relatively small account in a very short period of time.
If you are in the U.S., the maximum leverage you can get as a retail forex trader is 50 to 1. That’s a lot of leverage. But what does it really mean?
It means that if you have a $10,000 account, and you multiply that by 50 times leverage, you can control up to $500,000 in a position. That’s your maximum amount of leverage.
Now, this is what we call trading on margin. And it’s obviously very attractive. It’s exciting to be able to control 50 times your money. Let me give you a quick example of how powerful it can be…
Let’s assume we’re using our maximum leverage. We’re using $500,000 on our $10,000 account.
And say we short the Australian dollar against the U.S. dollar at 0.68254, and we ride this trade down all the way down to 0.68.
That gives us a tiny net move, which is normal in forex. We’re often looking at fractions of cents for movements in the currencies. That’s why we use leverage, so we can magnify our gains.
Now, if we multiply this change between the Australian dollar and the U.S. dollar times 500,000 – which is the maximum amount we’d be able to control through a broker – we’d get a decent gain. We’d make $1,270 on that trade.
Not bad, right? But remember, we could also lose that amount. We could even lose a lot more than that amount.
That’s why I like to think of leverage as a power tool. For example, a chainsaw can be a very powerful tool – so long as you know how to use it and you take the right safety precautions.
It’s the same thing with leverage. Leverage is just a tool. And like any tool, it has to be respected, because it can cut both ways.
The last thing we want to do with our metaphorical chainsaw is cut off our own leg.
Using Leverage Wisely
Now, if you use high leverage trade in and trade out, it’s a great way to blow your account in record time.
At that point, you might as well just go to the casino and put all your money on doubles at the roulette table and see what happens.
Let’s put this in perspective, using our example above. If we lose $1,270 out of our $10,000 account, we’ve instantly lost almost 13% of our money.
That’s a big swing. You take on three trades like that, and you’ve lost 38% of your total equity. That’s why leverage has to be respected. We can make 38%, but we can lose 38% too.
Always remember: As a trader, your number one responsibility is to preserve your capital. Longevity is the key to making wealth in this business. It is not trying to make big trades and fast money overnight.
By now, though, you’re probably wondering: What is an appropriate amount of leverage?
Leverage is not a one size fits all situation. It comes down to your personal risk tolerance. But personally, Andy and I don’t like to be highly leveraged. We often like to start out under 1-to-1 leveraged, and then we’ll build up.
Our general rule is that the more profits we have, the more comfortable we feel increasing the amount of leverage. So we raise our level of leverage depending on how well we’re trading.
Why? Because we want to use more leverage with the market’s money – not with the money we initially put in with our broker. That said, it’s very rare for us to be more than three or four times leveraged.
Remember, as traders, we want to limit our downside and maximize our upside at all times. That’s why you should use leverage wisely… and only use leverage when the conditions are favorable for you.
Editor, Money Trends
P.S. At our Big Trades advisory, Andy and I identify the key moves in the currency markets… And we give subscribers precise entry and exit points to play them. If you’re not a paid-up subscriber yet, learn more about how to get our latest trades delivered to your inbox, right here.
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