How to Use Leverage Responsibly in your Forex Trading
By: Hillel Fuld
The Forex market is a unique one. It is unique for many different reasons. It is the biggest market on the globe with anywhere between 3 and 5 trillion dollars traded every day, depending who you ask. It is also the most leveraged market with the possibility to trade positions of $20,000 with as little as $50 in your account, if you are using the market's maximum 400:1 leverage.
The topic of leverage is a sensitive one, with some experts swearing by it as the best strategy for your trading account, and others warning you to stay far away from leverage, since it will only guide you on your way to failure in your trading.
So, how is this discrepancy in opinions regarding leverage in the Forex market explained? How is it possible that two experts who agree on everything else regarding the Forex market, can disagree so strongly when it comes to the most basic principle of the Forex market?
The answer is that these two experts agree on the potential that leverage brings to the table and they also agree about the danger that it presents. The point of dispute between these two experts is how the average trader would leverage their account.
It is pretty safe to say that everyone agrees if you use leverage responsibly and treat it with the caution it deserves, than it is an effective tool that can produce unprecedented results.
It is also a safe assumption that if you do not, it will bring devastating results to your account and it will mean the end of your Forex account in no time. So how can a trader benefit from leverage while not increasing their risk by tens of percents? Is it really possible to use this trading strategy known as leverage without bringing your Forex account to a screeching halt known as a Margin call?
The answer is it is very possible to use leverage in your account and not increase the risk to the point of no return. How? Two words: Money management. It has become cliché already to say it but the truth is there is no secret to Forex success besides responsibly managing your account and trading with complete discipline.
So, if you use leverage with a combination of professional management skills, you will be able to benefit from the leverage and not have to worry about the risk it brings with it.
Leverage has been compared to many things by many people. There have been those that compare it to a double sided sword. There have been those that compared it to a speeding car, and the truth is they are all correct analogies, yet they are incomplete as well.
Take the speeding car comparison. It is true that if you are driving your car at a high speed, any small turn of the steering might mean immediate death, which is compared to a small decrease in the currency you are trading with a high leverage. As we said, this is a perfect yet incomplete analogy, because at the end of the day, we all use cars and drive faster, as opposed to walking.
We do this because we know it will bring us to our destination quicker, and we trust ourselves to drive responsibly. I have never heard of anyone who refuses to drive a car because it is too dangerous. Same applies to leverage, it is dangerous, but it will help you reach your financial destination faster, and should not be avoided, but rather used responsibly.
OK, enough general comments, let's get down the nitty gritty. How does one leverage their trading account responsibly?
The first thing you should do as a Forex trader, which will minimize your risk even if your account is leveraged, is define your risk profile. Sit down and define how much of your account you are willing to risk on each trade. If 2% is your magic number, then trade with that rule being your guiding light. If you chose 2%, then you are sure to stay in the game for a more extended period of time, leverage or no leverage.
This is a golden rule in trading Forex. Decide what you can afford to lose before you actually jump in and take the risk. Define a Stop Loss based on this decision, and you will be able to see smaller but steadier profits.
The flip side of the risk profile coin, is to make sure your Stop Losses are not in a place that will induce a closing of all your positions right before the market jumps back. Take the currency's range into account, and place your Stop Loss at a level that will allow your account to rebound and not get closed every time the currency decreases a little.
What that means practically is that if your risk profile is 2% of a $10,000 capital, you can only afford to lose $200. If a $200 decrease in the currency is something that will occur very often and is sure to close your positions if the Stop Loss is placed at that level, you might want to consider trading on a smaller time frame, such as hourly.
If a $200 loss is a regular occurrence on a daily chart, it will be a rarer occurrence on an hourly one, enabling you to trade with your risk profile rule, while still allowing the currency to do its thing.
These two factors create a balancing act between implementing a safety net via Stop Losses, and letting your account fluctuate just enough to bring in small and consistent profits. Using these two techniques in your Forex trading, will still allow you to use leverage, and benefit from its endless potential, while avoiding the danger Forex experts warn you about regularly.