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FOREX: How to Determine Appropriate Effective Leverage

FOREX: How to Determine Appropriate Effective Leverage

2012-01-10 15:30:00
Jeremy Wagner, CEWA-M, Senior Strategist
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A common question traders ask in our courses is how much leverage should I use? In our trading courses, we frequently talk about using less than 10 times effective leverage.

To get started, let’s look at what leverage is and why it is important to generally use less leverage rather than more leverage. Later on, we will explain the simple calculations needed to determine the effective leverage on your trading account.

What is leverage?

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.

Understanding the pros and cons of using leverage in forex.

For example, when you buy a house on credit, you are actually leveraging your personal balance sheet. Let’s say you wish to buy a $200,000 house but you don’t have that much cash on hand. So you put a 20% down payment of $40,000 on the house and make regular payments to the bank. In this case, you are using a small amount of cash ($40,000) to control a larger asset ($200,000 house).

In the stock market, many margin accounts allow you to lever up your purchases by a factor of 2. So if you have a $50,000 deposit into a margin account, you are allowed to control $100,000 of assets.

How is Effective leverage calculated?

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.

($200,000 / $40,000 = 5 times)

In the stock market example, our leverage is 2 times. ($100,000 / $50,000 = 2 times)

There is simple formula to determine your account’s effective leverage. This formula is printed below:

Total Position Size / Account Equity = Effective Leverage

EXAMPLE:

Now, let’s take a hypothetical trader and calculate their effective leverage in their forex account. Let’s assume that a trader with $10,000 equity has 3 positions open noted below:

The traders total position size is 70,000. (20k + 40k + 10k)

Using the formula noted above, the trader’s effective leverage is 7 times.

(70,000 position size / $10,000 Account Equity = 7 times)

How do I know how much leverage to use?

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 200 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.

Why do we encourage lower leverage?

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.

Scenario: Trader A buys 50 lots of AUD/USD while Trader B buys 5 lots of AUD/USD.

Questions: What happens to Trader A and Trader B account equity when the AUD/USD price falls 100 pips against them?

Answer: Trader A loses 50.0% and Trader B loses 5.0% of their account equity.

Example

TRADER A

TRADER B

Account Equity

$10,000

$10,000

Notional Trade Size

$500,000 (Buys 50, 10K lots)

$50,000 (Buys 5, 10K lots)

Leverage Used

50:1 (50 times)

5:1 (5 times)

100 Pip Loss in Dollars

-$5,000

-$500

% Loss of Equity

50.0%

5.0%

% of Equity Remaining

50.0%

95.0%

By using lower leverage, Trader B drastically reduces the dollar drawdown of a 100 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.

Why does the average trader lose money? We studied over 30 million trades to help you become a more consistent trader. On page 4 of our Traits of Successful Traders Guide, we discuss the most common trading mistakes.

Next: Understanding Forex Trade Sizes Using Notional Value (43 of 48)

Previous: How Effective Leverage Affects Forex Profitability

---Written by Jeremy Wagner, Lead Trading Instructor, DailyFX Education

To contact Jeremy, email jwagner@dailyfx.com. Follow me on Twitter at @JWagnerFXTrader.

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