How to Use Leverage in Forex Trading

Understanding leverage and how to use it can be the difference between you going broke very quickly and you actually making money. I occasionally read a forum post where some guy claims that he made x amount of dollars trading forex with a 100:1 margin and while it is possible, it is also extremely risky. Most beginning forex traders simply don't understand what they are betting when it comes to leverage. Forex trading can be extremely risky and the higher the leverage the higher the risk. Hopefully after you have read this, you will understand why playing with a high leverage is alot like playing with a loaded gun.

I have one caveat to say before we enter this realm. Just like sports gambling (something that I know a thing or two), forex trading can be a goldmine for those that understand the risks associated with it. With just a little knowledge on how things are run and with a couple technical indicators, you can make money on the FX market. However, just like sports gambling, if you bet the farm on one game and lose, you are taken out of the race. The foreign exchange market is no different. And the fact that you can leverage large currency amounts (lots), makes this endeavor very risky. That said, those that profit the most understand when to take risks and when to sit it out. We are going to explore this today...

Understanding how Leverage Works

The forex market works in using PIPs. A PIP is worth roughly 1/100th of a penny. Needless to say, this little amount of money is hardly worth trading, right? Well, in the forex market, most traders will work with lots which is 100,000 units of currency. In other words, if the USD/Euro pair was currently being traded for $1.0054, then one lot would be worth over $100,000 if the trader was risking his own money dollar for dollar (1:1)

Now most traders don't have this kind of capital to trade with. This is where leverage comes in and the confusion begins.

Here is a real world example:

You have $1,000 (which is low by the way) and decide that leveraging at a 1:25 level would be good because you can make a ton of money quickly...pay off the mortgage and retire in the bahamas by next year. At least that is your dream. After all, by leveraging 1:25, you are essentially controlling $125,000 dollars (assuming you are trading lots, not mini-lots because after all, you are a dreamer).

So, you enter a trade, with those dreams of getting rich quick in mind. However, the market moves against you. How much can you lose before you get that margin call? If you answered 2%, you would be correct. So, of the market moves against you and you lose 2% of your bankroll, you will be standing on the sideline with all the other forex trading amateurs wondering what in the heck just happened.

The end result is you get a margin call and are left with two choices:

1. Liquidate Your Account and call it a loss.
2. Add more money to your account.

It is safe to assume that most beginner forex traders don't have the capital to add more money to their account. In fact, most people who begin forex trading just think that it is a way to get rich quick.

Now, while this is a hypothetical example, don't think for a moment that it doesn't happen. Forex trading is full of losers who bet their bankroll without fully understanding the risks. And the worst part is that this margin call that I used in the previous example is conservative....most forex traders trade with 50:1 - 100:1 leverage. Forex is risky folks but playing with such a high leverage and you would be better off taking your chances with jumping in front of a moving train and hoping to live.

How to Use Leverage in Forex Trading

Since we have established that using too much leverage can be catastrophic to your account, let's examine how much leverage you should use when you are trading forex (or any market).....

A good rule of thumb is to not use more than 60% of your margin on any one trade. I think that this is a bit high personally, but you can decide for yourself what kinds of risk you are comfortable with.

If you are just starting out and getting a feel for the market using real dollars, chances are you are going to want to start small. 1:10 leverage is a good place to start because:

• It allows you to actually lose a few trades and still be in the game.
• It allows you to get a feel as to how much leverage is too much leverage for your risk taking.

Pay special attention to point #1. Staying in the game should be your number one goal. If you don't know how to use leveraging in forex trading, I would say that your chances of staying in the game aren't great. Learning how to leverage and when to leverage will most certainly increase your odds of not going broke quickly.