In forex trading, leverage means that with a small amount of capital in your account, you can open and control a much larger trading position.
For example, with a $1,000, your broker might allow you to open a $100,000 position. This is 100:1 leverage.
The advantage of using leverage is you can magnify gains with a limited amount of capital.
The disadvantage of leverage is that you can also magnify your losses and quickly blow your account!
When trading with excessive leverage, a small price swing can wipe out your entire account balance.
The greater the leverage level you use, the greater the swings in your account equity. In most cases, you end up with a margin call.
When your account equity is jumping around due to your highly levered positions, good luck keeping your emotions in check and not letting it affect your thinking.
Nobody will want to be around you when this is happening.
When trading with low (or no) leverage, you will give your trade “room to breathe” and protect your trading capital.
For example, you’ll be able to accommodate wider stop losses while keeping your risk limited.
The higher your leverage, the greater your risk on each trade, likely resulting in irrational decision making.
Knowing the link between leverage and your account equity is crucial since it determines your true leverage.
Here’s a study that was done by a popular forex broker showing the percentage of profitable traders by average true leverage.
As you can see, profitability declines substantially as true leverage increases!
40% of traders using true leverage of 5:1 or lower were profitable, compared to only 17% of traders using 25:1 leverage or higher.
Most professional traders trade with very low true leverage and rarely go above 10:1. That’s how they stay in the game.
Regardless of the leverage amount that your broker offers, you can emulate these lower leverage levels by simply depositing more money in your account and managing your risk properly like using proper position sizing.
Use true leverage of 10:1 or lower.
Only risk 10% or less of your account balance at any given time. Never let the value of all your trades open exceed 10 times your account equity.
To calculate your true leverage of a single trade, divide your trade size by your account equity.
For example, if you open an account with $5,000 in equity, a 10:1 leverage would mean opening positions no larger than $50,000 (or ~5 mini or 50 micro lots) at a time.
The lower the leverage, the safer. For example, a 2:1 leverage would mean opening positions no larger than $10,000 (or ~10 micro lots) at a time.
If you care about longevity as a trader, the LESS leverage you use, the better.
Having access to high leverage doesn’t mean you need to use it!
When you first open your live account, try to start trading with ZERO leverage.
For example, if you have $5,000 in your trading account, don’t open any positions larger than $5,000 (or ~5 micro lots) at a time.
With experience, you’ll learn when it’s best to use leverage, and how much leverage to apply, to help you achieve your financial goals.