Another common question I get asked at the website is about leverage, what it is, how much is a suitable amount for a trading account and if it is something a trader should worry about. These are good questions and so let me answer them in that order.
What is Leverage?
Leverage is an amount a broker lends a trader when taking a trade in order for them to trade a larger position with a smaller trading account. This is extremely beneficial to a trader, however while beneficial to a trader a trader needs to be aware that it has its limitations and while it can increase gains on a smaller account, it also can increase losses as well due to the larger amount on the positions that can be taken.
Let’s look at an example: let’s say a trader opens a position of $10,000 units ( buy or sell trade ) on a $2000 dollar trading account with a stop loss of 100 pips ( risking 5% of account ). This means that the trader has used leverage to open a position that is more than the trading account and that if leverage on that account is 100:1 that $100 dollars of margin is initially needed in order to open the trade ( $100 x 100 = $10,000 ). To the trader it means also that this position is $100 dollars of risk to stop loss on the $10,000 dollar position.
Common leverage amounts brokers offer traders on their trades:
- 50:1 = 50 times leverage
- 100:1 = 100 times leverage
- 500:1 = 500 times leverage
If say a trader was trading a 10,000 unit trade ( $10,000 dollar trade using leverage ) then $200 dollars of margin would be initially needed with a 50:1 leverage trading account, $100 dollars of margin would initially be needed with a 100:1 leverage account and $20 dollars of margin would initially be needed with a 500:1 leverage account.
Be aware that margin relates to the initially needed amount to take the trade and if position goes negative this adds to the margin used on an account. In other words, margin plus the negative profit amount on a position is the total margin being used on that trade. Opposite applies if trade goes into profit, in this case initial margin is reduced when profit is less than initial margin amount and available margin on trading acount is increased if profit on position exceeds initial margin requirement.
A Good Example of Controlling Risk:
It is important in trading when using any form of leverage to control and limit risk and exposure to the point that leverage has no consequences. Below is an example of this.
- Limiting risk to under 2% per position ( risk to stop loss ). This could be 2%, 1% or half a percent or even less. What I suggest is using a comfortable risk level under 2% that suits you as a trader.
- Limit exposure to an amount that does not over risk a trading account ( an example of this is limiting to under 4% exposure before management phase ).
If a traders account is $10,000 dollars and a trader is limiting risk to 1% per potential trade setup, then that means that this trader cannot risk more than $100 dollars per trade ( risk to stop loss on position ). Also if this trader is limiting exposure to 5% before management phase with their trading it means that the trader cannot have more than 5 positions open before management phase.
How Much Leverage is a Suitable Amount?
Anything above 50:1 is a good amount of leverage, whether it be 50:1, 100:1, 500:1 or even more. What I suggest is using a broker that offers a leverage amount that is suitable to your trading account size and to the trading method that you are trading.
A common leverage amount offered by brokers is 100:1 or more outside the U.S. and within the U.S. 50:1 is a common leverage amount.
Is High Leverage Dangerous?
Unless a trader is over risking per trade, leverage has little to no effect on a trading account. Leverage risk occurs when a trader takes a position or positions that is too large for the trading account size because of the extra leverage that the trader has available.
So in other words, leverage use is only dangerous in trading if a trader is risking more than the account can handle in a single trade or multiple trades..
Examples of keeping leverage use under account size ( low risk leverage use ):
- A low leveraged trade of risk on a $10,000 dollar account is 10,000 units or lower
- A low leveraged trade of risk on a $5,000 dollar account is 5,000 units or lower
Examples of leverage use where risk is more than account size ( medium risk leverage use ):
- A leveraged trade of risk on a $10,000 dollar account of over 50,000 units ( trade unit of risk over 5 times the account size )
- A leveraged Trade of risk on a $5,000 dollar account of over 25,000 units ( trade unit of risk over 5 times the account size )
Any comments of questions on this important topic in trading, let me know by commenting below.