Understanding how to trade foreign currencies requires detailed knowledge about the economies and political situations of individual countries, global macroeconomics, and the impact of volatility on specific markets. But the truth is, it isn’t usually economics or global finance that trip up first-time forex traders. Instead, a basic lack of knowledge on how to use leverage is often at the root of trading losses.
Data disclosed by the largest foreign exchange brokerages as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act indicates that a majority of retail forex customers lose money. The misuse of leverage is often viewed as the reason for these losses. This article explains the risks of high leverage in the forex markets, outlines ways to offset risky leverage levels, and educates readers on ways to pick the right level of exposure for their comfort.
Key Takeaways
- Leverage is the use of borrowed funds to increase one's trading position beyond what would be available from their cash balance alone.
- Forex traders often use leverage to profit from relatively small price changes in currency pairs.
- Since leverage, can amplify both profits as well as losses, choosing the right amount is a key risk determination for traders.
- Leverage in the forex markets can be 50:1 to 100:1 or more, which is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided in the futures market.
The Risks of High Leverage
Leverage is a process in which an investor borrows money in order to invest in or purchase something. In forex trading, capital is typically acquired from a broker. While forex traders are able to borrow significant amounts of capital on initial margin requirements, they can gain even more from successful trades.
In the past, many brokers had the ability to offer significant leverage ratios as high as 400:1. This means, that with only a $250 deposit, a trader could control roughly $100,000 in currency on the global forex markets. However, financial regulations in 2010 limited the leverage ratio that brokers could offer to U.S.-based traders to 50:1 (still a rather large amount). This means that with the same $250 deposit, traders can control $12,500 in currency.
So should a new currency trader select a low level of leverage such as 5:1 or roll the dice and ratchet the ratio up to 50:1? Before answering, it’s important to take a look at examples showing the amount of money that can be gained or lost with various levels of leverage.
Example Using Maximum Leverage
Imagine Trader A has an account with $10,000 cash. They decide to use the 50:1 leverage, which means that they can trade up to $500,000. In the world of forex, this represents five standard lots. There are three basic trade sizes in forex: a standard lot (100,000 units of quote currency), a mini lot (10,000 units of the base currency), and a micro lot (1,000 units of quote currency). Movements are measured in pips. Each one-pip movement in a standard lot is a 10 unit change.
Assuming the trader purchased five standard lots with the U.S. Dollar as the quote currency, then each one-pip movement will cost $50. If the trade goes against the investor by 50 pips, the investor would lose 50 pips x $50 = $2,500. This is 25% of the total $10,000 trading account.
Example Using Less Leverage
Let’s move on to Trader B. Instead of maxing out leverage at 50:1, they choose a more conservative leverage of 5:1. If Trader B has an account with $10,000 cash, they will be able to trade $50,000 of currency. Each mini-lot would cost $10,000.In a mini lot, each pip is a $1 change. Since Trader B has 5 mini lots, each pip is a $5 change.
Should the investment fall that same amount, by 50 pips, then the trader would lose 50 pips x $5 = $250. This is just 2.5% of the total position.
How to Pick the Right Leverage Level
There are widely accepted rules that investors should review before selecting a leverage level. The easiest three rules of leverage are as follows:
- Maintain low levels of leverage.
- Use trailing stops to reduce downside and protect capital.
- Limit capital to 1% to 2% of total trading capital on each position taken.
Forex traders should choose the level of leverage that makes them most comfortable. If you are conservative and don’t like taking many risks, or if you’re still learning how to trade currencies, a lower level of leverage like 5:1 or 10:1 might be more appropriate.
Trailing or limit stops provide investors with a reliable way to reduce their losses when a trade goes in the wrong direction. By using limit stops, investors can ensure that they can continue to learn how to trade currencies but limit potential losses if a trade fails. These stops are also important because they help reduce the emotion of trading and allow individuals to pull themselves away from their trading desks without emotion.
The Bottom Line
Selecting the right forex leverage level depends on a trader’s experience, risk tolerance, and comfort when operating in the global currency markets. New traders should familiarize themselves with the terminology and remain conservative as they learn how to trade and build experience. Using trailing stops, keeping positions small, and limiting the amount of capital for each position is a good start to learning the proper way to manage leverage.
FAQs
The best leverage in forex markets depends on the investor. For conservative investors, or new ones, a low leverage ratio of 5:1/10:1 may be good. For seasoned investors, who are more risk-friendly, leverages may be as high as 50:1 or even 100:1 plus.
Is 1/500 leverage good for a beginner? ›
Using high leverage , such as 1:500 , can potentially increase your profits , but it also comes with a higher risk of losing your entire account . If you are a beginner trader , it is not recommended to use such high leverage as it requires a lot of experience and discipline to manage effectively .
What leverage is good for $100 forex? ›
Many professional traders say that the best leverage for $100 is 1:100. This means that your broker will offer $100 for every $100, meaning you can trade up to $100,000. However, this does not mean that with a 1:100 leverage ratio, you will not be exposed to risk.
What is a good leverage to start forex trading? ›
What is the best leverage level for a beginner? If you are a novice trader and are just starting to trade on the exchange, try using a low leverage first (1:10 or 1:20). After you've gained some experience in Forex trading, you can gradually increase it. While doing so, always remember about the risk management system.
Is 1:50 leverage enough? ›
50:1 gives you more than enough leverage to swing trade and have a day trade or two at the same time. If you take multiple day trades at the same time, risking 1% of the account on each with a small stop loss, then you may need more than 50:1.
What is the best leverage for $10? ›
Here's a general guideline for determining optimal leverage based on account size:
- Account Size: $10 - $50 Recommended Leverage: 1:100 or lower.
- Account Size: $100 - $200 Recommended Leverage: 1:200 or lower.
- Account Size: $200+ Recommended Leverage: 1:300 - 1:500 (for experienced traders)
Therefore, the best leverage for a beginner is 1:10, or if you want to be safer, choose a leverage of 1:1, depending on the amount you are starting with. So, what leverage should I use on a $300 account? $300 is the minimum amount of money required in a mini lot account, and the best leverage on this account is 1:200.
How much leverage is safe in forex? ›
The best leverage in forex markets depends on the investor. For conservative investors, or new ones, a low leverage ratio of 5:1/10:1 may be good. For seasoned investors, who are more risk-friendly, leverages may be as high as 50:1 or even 100:1 plus.
What is the best leverage for $200? ›
100:1 is the best leverage that you should use. The most important thing is how much of your account equity you are willing to lose on a trade.
What is the best leverage for $5? ›
Generally, it's recommended to use lower leverage when you have a smaller account size to minimize the risk of significant losses. A leverage of 1:10 or 1:20 can be a good starting point for a $5 account.
When you trade forex with $100, it's recommended to open trades of no more than 0.01-0.05 lots so that risks should not exceed 5% of the deposit amount. To trade forex with $100, you will need the maximum leverage to lower the margin amount blocked by the broker.
What is the best lot size for $30? ›
The optimal risk of $30 a trade will allow you to trade 0.1 lots with an SL of 300 points. The potential growth will be $90. Depending on the percentage of your account you want to assign for a trade, there may be different combinations and the size of stop-loss in points you need for your trade may differ.
Is 1/1000 leverage good for beginners? ›
1:1000 leverage is not the best for beginners because of the margin call risk, which can cause big losses. Your capital will be significantly reduced after a few margin calls.
What is a healthy amount of leverage? ›
A financial leverage ratio of less than 1 is usually considered good by industry standards. A leverage ratio higher than 1 can cause a company to be considered a risky investment by lenders and potential investors, while a financial leverage ratio higher than 2 is cause for concern.
Is 1 200 leverage safe? ›
With a leverage ratio of 1:200, you have the ability to control positions that are 200 times larger than your capital. This increased leverage can potentially result in higher profits, but it also carries greater risks.
What happens if you lose leverage in forex? ›
When trading with leverage, you are essentially borrowing money from your Forex broker to finance your trade. If the value of your investment falls, you will not only lose the money that you have invested but also the money that you have borrowed.
What is the best leverage ratio for beginners? ›
As a beginner trader, it is crucial to start with low leverage. This will help you to limit your losses and learn how to manage your risk effectively. A good rule of thumb is to start with leverage of 1:10 or lower. This means that for every $1,000 in your trading account, you can control a position worth $10,000.
What is the margin for 1 500 leverage? ›
To understand the difference between 1:30 and 1:500 leverage, let's take the example of trading 1 lot of EUR/USD. With 1:30 leverage, a trader would require a margin of $3,333.33 (1/30th of the position size), while with 1:500 leverage, the required margin would be $200 (1/500th of the position size).
What is the best leverage for a $5 account? ›
Generally, it's recommended to use lower leverage when you have a smaller account size to minimize the risk of significant losses. A leverage of 1:10 or 1:20 can be a good starting point for a $5 account.
Is leverage 1 1000 good for beginners? ›
A leverage ratio of 1:1000 provides the highest level of amplification, allowing you to control positions that are 1000 times larger than your capital. This level of leverage carries significant risks and is generally not recommended for beginners.
