A common question traders ask in our courses is how much leverage should I use? In our trading courses, w e frequently talk about using less than 10 times effective leverage. Later on, we will explain the simple calculations needed to determine the effective leverage on your trading account.
Leverage refers to using a small amount of one thing to control a larger amount of something else. As individuals, we use leverage to some degree in a portion of our daily lives. For example, when you buy a house on credit, you are actually leveraging your personal balance sheet. In the stock market, many margin accounts allow you to lever up your purchases by a factor of 2.
To determine the amount of effective leverage used, simply divide the larger asset by the smaller instrument. So in our housing example, we divide the value of the house by the equity in the house which means the house was levered 5 times. In the stock market example, our leverage is 2 times. This formula is printed below: There is a relationship between leverage and its impact on your forex trading account. The greater the amount of effective leverage used, the greater the swings up and down in your account equity.
The smaller the amount of leverage used, the smaller the swings up or down in your account equity. In our trading courses, we frequently talk about using less than 10 times effective leverage. Just because you have access to a higher amount of leverage in your account does not necessarily mean you want to use all or any portion of it.
Think of it like an automobile or motorcycle. Just because the machine could run at speeds of miles per hour, that does not mean YOU necessarily need to drive it that fast.
You see, the faster you drive it, the more likely you are to get into an accident. Therefore, you are in greater risk of bodily injury driving at higher speeds and leverage is similar to that analogy. More leverage puts your trading account at risk. When you use excessive leverage, a few losing trades can quickly offset many winning trades.
To clearly see how this can happen, consider the following example. Trader A loses By using lower leverage, Trader B drastically reduces the dollar drawdown of a pip loss. For these reasons, that is why in my trading I choose to be even more conservative and oftentimes use less than 10 times leverage. The appropriate amount of leverage for you will be based on your risk appetite. An aggressive trader may utilize effective leverage amounts closer to 10 to 1. More conservative traders my utilize 3 to 1 or less.
To contact Jeremy, email jwagner dailyfx. Part 1 of 5. FX Transaction Basics Part 2 of 5. Currency Names and Symbols Part 3 of 5. Longs and Shorts Part 4 of 5.
Part 5 of 5. Further your education with our beginner and advanced trading guides. Click HERE for more information. DailyFX provides forex news and technical analysis on the trends that influence the global currency markets. Click here to dismiss. How to Determine Appropriate Effective Leverage. Swing trading, chart patterns, breakouts, and Elliott wave Connect via: How is Effective leverage calculated?
Why do we encourage lower leverage? This completes the 5 part series of New to Forex. Part 5 of 5 Additional Resources Further your education with our beginner and advanced trading guides. Foundations of Technical Analysis: Classic Chart Patterns, Part I. How to Trade with Support and Resistance. Upcoming Events Economic Event.
Forex Economic Calendar A:More...