One of the biggest drawbacks faced by traders on a daily basis is the failure to manage Forex leverage in an effective manner. Trading with leverage can go a long way in improving your returns, but it also raises the risk of losing big in case a trade failure occurs. Traders are al-lowed a leverage of nearly 400:1 in the currency market. In other words, you can trade $400 in borrowed money for every $1 sitting in your trading account.
But a majority of the traders generally prefer a significantly smaller leverage of 2:1. In other words, they can trade with $100,000 if they have $50,000 sitting in their trading ac-count.
If you are confused about the leverage you are using on your trading account right now, there is a simple formula to clear it up:
1. Consider the numerical value of all of your open positions.
2. And then divide it by the amount of money currently sitting in your trading account.
3. For example, if your open positions come up to $30,000 and your trading account stands at $5,000, then your effective leverage would be 6.
Once you understand the amount of leverage you are utilizing, you can go about assessing if it is optimal for your trading strategy or style. Aggressive traders with a high threshold for risk can have a maximum leverage of 10:1. Conservative traders usually limit themselves to utiliz-ing a leverage of around 2:1 or 3:1.
Forex brokers always advise traders to limit or reduce their leverage usage. A high lev-erage means a few bad trades will empty your trading account. This will eventually lead to a margin call or the loss of all of your positions.
Let us go through one such scenario. Assume that your trading account has $10,000 in it and that you are utilizing a leverage of 100:1. You are trading 10 mini-lots which are worth $1 million. Now if you were to make a 100 pip loss at this juncture, it will set you back $10,000. This means that your trading account has just been wiped out.
In a different scenario, assume that your leverage is just 10:1 and your trading account stands at $10,000. You are trading 5 mini-lots which are worth $100,000. In this case, a 100 pip loss would set your trading account back by only $5,000. This means that you will still have $5,000 left in your account at the end of the day.
Another compelling advantage of utilizing less leverage is the massive savings made from transaction fees. If your choice of trade comes with a five pip spread, the transaction fee will cost you $500, or a 5% cut of whatever is in your trading account.
In other words, you have already lost $500 before you have even gotten the chance to en-joy the profit you have made from your trade. The cost of transaction is directly proportional to the leverage you use. The bigger the leverage, the higher the transaction fee. The lower the leverage, the lower the transaction fee.
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