Leverage gives traders the ability to open positions with trade sizes larger than their account equity. We want to be careful when using leverage as this magnifies both our trades’ gains and losses, but how can leverage be controlled? How do we determine the amount of leverage we are using at any given time? These are the questions we will cover in today’s article.
Margin Can Be a Distraction
Let's say a trader logs into their trading account and finds the amount of margin required to trade 10,000 units of USD/JPY is $200...which means $200 is set aside from my account’s equity. If we wanted to open a 100k trade, that would take $2000 to be set aside, etc.
At this exact moment, many traders begin to look at leverage the wrong way. We see the margin required, we look at our account’s equity level and then figure out how much we can open. So a trader with a $2,500 account might feel comfortable opening a 100K USDJPY position because it only requires $2,000, but that would be a terrible decision. Why? Because we would be leveraging our account 40 times!
How We Should Calculate Leverage
So where did we go wrong with our trade? We were so distracted by the margin requirement that we forgot to look at what we were actually trading, $100,000 US Dollars against the Japanese Yen. $100,000 is 40 times our $2,500 equity that we deposited into our trading account. Using this amount of leverage is very dangerous and actually decreases the chance we will be profitable traders in the long run.
To solve this problem, we need to first look at the actual trade size in relationship to how much equity we have in our account. We need to calculate what each trade’s notional value is and make sure it is not too large for our risk appetite. A good rule of thumb that I follow is never trade more than 10 times your account’s equity across all of your open trades.
For example, our $2,500 account… we would multiply $2,500 by 10 to get to $25,000. That means we could open up a maximum of 2 mini lots in USD/JPY and be within the rule of 10. The best part is, as long as we always keep our trades less than 10 times our equity, we don’t need to worry about how much margin each pair requires. The formula insures our account will be well capitalized for the positions we have open.
Register for a FREE demo account and open a trade no larger than 10 times your account's equity. This will give you an idea of how price fluctuations affect your account while using reasonable amounts of leverage.
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---Written by Rob Pasche