Hopefully I’ve done my job and you now have a better understanding of what “margin” is. Now I want to take a harder look at “leverage” and show you how it regularly wipes out unsuspecting or overzealous traders.
We’ve all seen or heard online forex brokers advertising how they offer 200:1 leverage or 400:1 leverage. I just want to be clear that what they are really talking about is the maximum leverage you can trade with. Remember this leverage ratio depends on the margin required by the broker. For example, if a 1% margin is required, you have 100:1 leverage.
There is maximum leverage. And then there is your true leverage.
True leverage is the full amount of your position divided by the amount of money deposited in your trading account.
Huh?
Let me illustrate an example:
You deposit $10,000 in your trading account. You buy 1 standard 100K of EUR/USD at a rate of $1.0000. The full amount of your position is $100,000 and your account balance is $10,000. Your true leverage is 10:1 ($100,000 / $10,000)
Let’s say you buy another standard lot of EUR/USD at the same price. The full amount of your position is now $200,000 and your account balance is still $10,000. Your true leverage is now 20:1 ($200,000 / $10,000)
You’re feeling good so you buy three more standard lots of EUR/USD, again at the same rate. The full amount of your position is now $500,000 and your account balance is still $10,000. Your true leverage is now 50:1 ($500,000 / $10,000).
Assume the broker requires 1% margin. If you do the math, your account balance and equity are both be $10,000, the Used Margin is $5,000, and the Usable Margin is $5,000. For one standard lot, each pip is worth $10.
In order to receive a margin call, price would have to move 100 pips ($5,000 Usable Margin divided by $50/pip).
This would mean the price of EUR/USD would have to move from 1.0000 to .9900 – a price change of 1%.
After the margin call, your account balance would be $5,000. You lost $5,000 or 50% and the price only moved 1%.
Now let’s pretend you ordered coffee at a McDonald’s drive-thru, then spilled your coffee on your lap while you were driving, and then proceeded to sue and won against McDonald’s because your legs got burned and you didn’t know the coffee was hot. To make a long story long, you deposit $100,000 in your trading account instead of $10,000.
You buy just 1 standard lot of EUR/USD – at a rate of 1.0000. The full amount of your position is $100,000 and your account balance is $100,000. Your true leverage is 1:1.
Here’s how it looks in your trading account:
In this example, in order to receive a margin call, price would have to move 9,900 pips ($99,000 Usable Margin divided by $10/pip)
This means the price of EUR/USD would have to move from 1.0000 to .0100! This is a price change of 99% or basically 100%!
Let’s say you buy 19 more standard lots, again at the same rate as the first trade. The full amount of your position is $2,000,000 and your account balance is $100,000. Your true leverage is 20:1.
In order to be “margin called”, price would have to move 400 pips ($80,000 Usable Margin divided by ($10/pip X 20 lots)
That means the price of EUR/USD would have to move from $1.0000 to $0.9600 – a price change of 4%.
If you did get margin called and your trade exited at the margin call price, this is how your account would like:
You would have realized an $80,000 loss! You’ would’ve wiped out 80% of your account and the price only moved 4%!
Do you now see the effects of leverage?!
Leverage amplifies the movement in the relative prices of a currency pair by the factor of the leverage in your account.
Here’s a chart of how much your account balance changes if prices moves depending on your leverage.
Leverage | % Change in Currency | % Change in Account |
100:1 | 1% | 100% |
50:1 | 1% | 50% |
33:1 | 1% | 33% |
20:1 | 1% | 20% |
10:1 | 1% | 10% |
5:1 | 1% | 5% |
3:1 | 1% | 3% |
1:1 | 1% | 1% |
Let’s say you bought USD/JPY and it goes up by 1% from 120.00 to 121.20. If you trade one standard $100K lot, here is how leverage would affect your return:
Leverage | Margin Required | Return (Gain) |
100:1 | $1,000 | +100% |
50:1 | $2,000 | +50% |
33:1 | $3,300 | +33% |
20:1 | $5,000 | +20% |
10:1 | $10,000 | +10% |
5:1 | $20,000 | +5% |
3:1 | $33,000 | +3% |
1:1 | $100,000 | +1% |
Let’s say you bought USD/JPY and it goes down by 1% from 120.00 to 118.80. If you trade one standard $100K lot, here is how leverage would affect your return (or loss):
Leverage | Margin Required | Return (Loss) |
100:1 | $1,000 | -100% |
50:1 | $2,000 | -50% |
33:1 | $3,300 | -33% |
20:1 | $5,000 | -20% |
10:1 | $10,000 | -10% |
5:1 | $20,000 | -5% |
3:1 | $33,000 | -3% |
1:1 | $100,000 | -1% |
The more leverage you use, the less “breathing room” you have for the market to move before a margin call.
You’re probably thinking I’m a day trader, I don’t need no stinkin’ breathing room. I only use 20-30 pip stop losses.
Okay let’s take a look:
Example #1
You open a mini account with $500 which trades $10K mini lots and only requires .5% margin.
You buy 2 lots of EUR/USD. Your true leverage is 40:1 ($20,000 / $500). You place a 30 pip stop loss and it gets triggered. Your loss is $60 ($1/pip x 2 lots).
You’ve just lost 12% of your account ($60 loss / $500 account). Your account balance is now $440.
You believe you just had a bad day. The next day, you’re feeling good and want to recoup yesterday losses, so you decide to double up and you buy 4 lots of EUR/USD. Your true leverage is about 90:1 ($40,000 / $440). You set your usual 30 pip stop loss and your trade loses. Your loss is $120 ($1/pip x 4 lots).
You’ve just lost 27% of your account ($120 loss/ $440 account). Your account balance is now $320.
You believe the tide will turn so you trade again. You buy 2 lots of EUR/USD. Your true leverage is about 63:1. You set your usual 30 pip stop loss and lose once again! Your loss is $60 ($1/pip x 2 lots).
You’ve just lost almost 19% of your account ($60 loss / $320 account). Your account balance is now $260.
You’re getting frustrated. You try to think what you’re doing wrong. You think your setting your stops too tight.
The next day you buy 3 lots of EUR/USD. Your true leverage is 115:1 ($30,000 / $260). You loosen your stop loss to 50 pips. The trade starts going against you and it looks like you’re about to get stopped out yet again!
But what happens next is even worse! You get a margin call!
Since you opened 3 lots with a $260 account, your Used Margin was $150 so your Usable Margin was a measly $110. The trade went against you 37 pips and because you had 3 lots opened, you get margin called. Your position has been liquidated at market price.
The only money you have left in your account is $150, the Used Margin that was returned to you after the margin call.
After four total trades, your trading account has gone from $500 to $150. A 70% loss! It won’t be very long until you lose the rest.
Trade No. | Starting Account Balance | Number of Lots Used | Stop Loss Size (pips) | Trade Result | Ending Account Balance |
1 | $500 | 2 | 30 | -$60 | $440 |
2 | $440 | 4 | 30 | -$120 | $320 |
3 | $320 | 2 | 30 | -$60 | $260 |
4 | $260 | 5 | 50 | Margin Call | $150 |
A four trade losing streak is not uncommon. Experienced traders have similar or even longer streaks. The reason they’re successful is because they use low leverage. Most cap their leverage at 5:1 but rarely go that high and stay around 3:1.
The other reason experienced traders succeed is because their accounts are properly capitalized!
While learning technical analysis, fundamental analysis, building a system, trading psychology is important, I believe the biggest factor on whether you succeed as a forex trader is making sure you capitalize your account sufficiently and trade that capital with smart leverage.
Your chances of becoming successful are greatly reduced below a minimum starting capital. It becomes impossible to mitigate the effects of leverage on too small an account.
Low leverage with proper capitalization allows you to realize losses that are very small which allows you to trade another day.
Example #2
Bill opens a $5,000 account trading $100,000 lots. He is trading with 20:1 leverage. The currency market moves on a regular basis anywhere from 70 to 200 pips in one day. In order to protect himself, he uses tight 30 pips stops. If the market goes 30 pips against him, he would be stopped out for a loss of $300.00. He felt that was reasonable but he underestimated how volatile this market is and found himself being stopped out frequently.
After being stopped out four times, he’d had enough. He’s decided to give himself a little more room, handle the swings, increases his stop to 100 pips.
Bill’s leverage is not 20:1 anymore, his account is down to $2,800 (his four loses at $300 each) and he’s still trading one $100,000 lot. It’s now over 25:1.
He decides to tighten his stops to 50 pips. He opens another trade using two lots and two hours later his 50 pip stop loss is hit and he losses $1,000. He now has $2,800 in his account. His leverage is 35:1.
He tries again with two lots. This time the market goes up 10 pips. He cashes out with a $200 profit. His account grows slightly to $3,000.
He opens another position with two lots. The market drops 50 points and he gets out. Now he has $2,000 left.
He thinks what the hell and opens another position. The market proceeds to drop another 100 pips and because he has $1,000 locked up as margin deposit, he only has $1,000 margin available, so he receives a margin call and his position is instantly liquidated.
He now has $1,000 left which is not even enough to open a new position.
He lost $4,000 or 80% of his account with a total of 8 trades and the market only moved 280 pips. 280 pips! The market moves 280 pips pretty darn easy.
Are you starting to see why leverage is the top killer of forex traders?
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