Leverage poses two major problems for Forex traders and if you don't understand there impact, you are going to join the vast majority of losers. Let's look at how to use Forex leverage correctly, for bigger FX Profits and avoid the mistakes of the majority...
The number one reason traders fail is they don't understand how leverage really works. Just because brokers allow you to Leverage up by 200:1 or more, doesn't mean you should! We will show you why you should never use the whole amount of leverage you are given and give you some guidelines on the right leverage in a moment but let's look at it in more detail.
The definition of "leverage" is simply having the ability to control a large amount of money with a small deposit.
For example, in forex, you can control $100,000 with a $500.00 deposit. Your leverage is therefore 200:1. Let's say the $100,000 investment rises in value to $101,000 or plus $1,000.
If you had to deposit the $100,000 capital yourself, your return would be a $1,000 gain on a deposit of $500 deposit or 200%. This looks great but now let's look at what would happen if prices had moved the other way. In movement terms it's simply - 1% but in terms of your margin, you would lose you entire account at a - 0.5% swing against you or have to more than double your investment to simply stay in the game.
0.5% swings are nothing when Forex markets are volatile so you need to de leverage and we will give you the optimum leverage in a moment but first - You may say I knew that!
Maybe you did but let's look at problem leverage causes which is transaction cost impact.
Not only does leverage increase your potential losses, it also increases your transaction costs as a percentage of your account. The higher your leverage, the higher your transaction cost as a percentage of your trading capital.
On the example below, you can see that the impact on your actual deposited amount is a whopping 10%!
Leverage 200:1 Margin $50 transaction cost at 5 pip spread = 10%
This means you have to make 10% just to break even and that's a sizeable amount on just one trade.
High leverage is a favorite selling point for most forex brokers and we have used a 200:1 example but I have seen brokers offer 500:1 or more but you don't need anywhere near this amount.
When you start don't use it at all and when you do decide to use 10 - 20 times leverage is plenty!
Be sensible when using leverage and you can use it to your advantage, leverage up to much and it will simply destroy your account.
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