Did your broker ever tell you that you can leverage your trade? Here is a quick primer if you aren’t familiar with the term.
Leverage (also called buying on margin) means that you can borrow funds to place your trades. For example, let’s assume that you have $500 in your account. You could borrow $4,500 from your broker to place a $5,000 trade. This means that your account would be leveraged 10:1.
Leverage can be a great way to increase your return. In this case, you would magnify your return 10 times over. The downside with leverage is that it also magnifies your losses proportionally as well.
Dangers of Overleveraging
You shouldn’t be afraid to buy on the margin for fear of making some bad trades. You will inevitably make some wrong trades with or without being leveraged. The problem is that taking on too much leverage can completely wipe you out. Here are some things that you need to keep in mind.
You May Face Margin Calls
You need to put aside enough money in your account to cover any losses that you incur. The money that you set aside to cover losses is known as the usable margin. Your broker will allow you to keep a trade open until the loss is equal to your usable balance margin.
This is a complex topic, so let me illustrate with an example. You opened an account with $1,000. You decide that you want to buy 10 mini lots (10,000 units) of the EUR/USD. You decide to use $500 to place a $100,000 trade by leveraging your account 200:1. This leaves you with a usable margin of $500.
Every pip is worth about $10, which means that even small fluctuations can have a substantial impact on your account. You will get a margin call as soon as it falls 50 pips below the purchase price. You would either need to increase the size of your usable margin or close the trade.
Why Margin Calls are a Concern?
As I stated earlier, your losses are significantly higher when your account is leveraged. Rather than losing $50, you will lose $1,000 if your account is leveraged 200:1. This can obviously cost you a lot of money if you made a bad trade.
However, being overleveraged can also cost you if you made the right trade. You may have accurately predicted that the currency would increase by 100 pips in the next 48 hours. However, the forex market is often very volatile. The price may drop by 50 pips before rebounding to the strike price. You would face a margin call and close your trade at a $500 loss before you got to realize your profit.
Placing a trade at a 200:1 margin would have been the wrong decision in this case. What would have happened if you leveraged your account 50:1 instead? Each pip would only be worth about $2.50. You would still have $375 in your usable margin if the price dropped by 50 pips, which means that you wouldn’t receive a margin call from your broker. By the time the price rebounds to 100 pips above the purchase price, you would have earned a profit of $250.
Your leverage ratio would have made the difference between a $250 profit and a $500 loss. It is important to keep that in mind when making a trade.
How Much Leverage Should You Use?
Everybody forex trader makes mistakes. You will become better at investing over time. However, you need to make sure that you don’t lose your shirt before you have a chance to learn the lessons. If you are a beginning forex investor, then you will probably want to use a much more conservative leverage ratio. Some investors recommend using a ratio of 3:1 or having no leverage at all.
Even seasoned traders need to be careful when making trades. Many aggressive traders use leverage ratios under 10:1. More cautious investors may use a leverage ratio of 3:1 or less.
Choosing a leverage ratio is a blend of art and science. Here are some things that you will want to keep in mind:
- The market volatility. Prices can fluctuate much more significantly at some times than others. The average daily movement for the EUR/USD was 185 pips in 2008, compared to 110 pips in 2013. You can face a margin call much more quickly in a volatile market, so a lower leverage ratio would be smarter.
- Correlation between currency pairs. Prices can vary considerably between different currency pairs. Average movement between the EUR/USD last year was 110 pips, while the GBP/JPY was 189. You would probably want to use a lower leverage ratio if you were trading the second pair.
- Duration of your strategy. You will need to consider how long it will take to execute your trade. You may plan to keep your trade open for three days. It may be a good idea to set your usable margin so that you could incur an “average” loss for at least two of those days. If the average pip movement for your currency pair in the current market seems to 150 pips then you may want to make sure that your usable margin can cover a 300 pip drop. You may want to be even more conservative if the market is starting to become even more volatile.
Shaun also prepared a great video showing how the risk of any given trade affects a trader’s chances of blowing up.
There are a lot of factors to keep in mind when you are setting a forex margin. You will need to keep these in mind and decide how much risk you can take. Successful forex traders often leverage their investments, but they know how to do so wisely.