Choosing the Right Leverage in Forex Trading: A Guide

While knowledge of currencies is important in forex trading, it’s perhaps more crucial that investors understand the concept of leverage when trading in this market. First-time forex traders often suffer losses due to its misuse.

Leverage is the use of borrowed funds to increase one’s trading position beyond what would be available from their cash balance alone. Forex traders often use leverage to profit from relatively small price changes in currency pairs. Since leverage can amplify profits as well as losses, choosing the right amount is a key risk determination for traders.

Keep reading for insights into optimal leverage levels, associated risks, and strategies to mitigate those risks.

Understanding the Dangers of High Forex Leverage

Leverage is a process in which an investor borrows money in order to invest in or purchase something. In forex trading, capital is typically acquired from a broker. While forex traders are able to borrow significant amounts of capital on initial margin requirements, they can gain even more from successful trades.

In the past, many brokers had the ability to offer significant leverage ratios as high as 400:1. This means that with only a $250 deposit, a trader could control roughly $100,000 in currency on the global forex markets. However, financial regulations in 2010 limited the leverage ratio that brokers could offer to U.S.-based traders to 50:1 (still a rather large amount).1 This means that with the same $250 deposit, traders can control $12,500 in currency.

So should a new currency trader select a low level of leverage such as 5:1 or roll the dice and ratchet the ratio up to 50:1? Before answering, it’s important to take a look at examples showing the amount of money that can be gained or lost with various levels of leverage.

Real-World Scenario: Impact of Maximum Forex Leverage

Imagine Trader A has an account with $10,000 cash. They decide to use the 50:1 leverage, which means that they can trade up to $500,000. In the world of forex, this represents five standard lots. There are three basic trade sizes in forex: a standard lot (100,000 units of quote currency), a mini lot (10,000 units of the base currency), and a micro lot (1,000 units of quote currency). Movements are measured in pips. Each one-pip movement in a standard lot is a 10-unit change.

Assuming the trader purchased five standard lots with the U.S. dollar as the quote currency, then each one-pip movement will cost $50. If the trade goes against the investor by 50 pips, the investor would lose 50 pips × $50 = $2,500. This is 25% of the total $10,000 trading account.

Conservative Approach: Effects of Lower Forex Leverage

Let’s move on to Trader B. Instead of maxing out leverage at 50:1, they choose a more conservative leverage of 5:1. If Trader B has an account with $10,000 cash, they will be able to trade $50,000 of currency. Each mini lot would cost $10,000. In a mini lot, each pip is a $1 change. Since Trader B has 5 mini lots, each pip is a $5 change.

Should the investment fall that same amount, by 50 pips, then the trader would lose 50 pips × $5 = $250. This is just 2.5% of the total position.

Choosing the Optimal Leverage in Forex Trading

There are widely accepted rules that investors should review before selecting a leverage level. The easiest three rules of leverage are as follows:

1. Maintain low levels of leverage.
2. Use trailing stops to reduce downside and protect capital.
3. Limit capital to 1% to 2% of total trading capital on each position taken.2

Forex traders should choose the level of leverage that makes them most comfortable. If you are conservative and don’t like taking many risks, or if you’re still learning how to trade currencies, a lower level of leverage like 5:1 or 10:1 might be more appropriate.

Trailing or limit stops provide investors with a reliable way to reduce their losses when a trade goes in the wrong direction. By using limit stops, investors can ensure that they can continue to learn how to trade currencies but limit potential losses if a trade fails. These stops are also important because they help reduce the emotion of trading and allow individuals to pull themselves away from their trading desks without emotion.