Since a built-in risk management tool was added to The Amazing Trader (also as a stand-a-alone), I have been thinking how well it instills discipline into one’s trading. This also got me to thinking about leverage and the importance of understanding the good, the bad and the ugly of it. This is an article that all retail traders should read.
The Good
Forex markets move a lot less in percentage terms than equities or cryptos. A 1% daily range in a currency is considered large by current standards This is why leverage is seen as important in forex trading as it allows the trader to trade more than his/her equity to capitalize on relatively small moves. Leverage is an attraction (and a benefit) to forex traders if used prudently but can also be a detriment to those who do not understand it.
The Bad
Over leverage is generally the term most commonly used when looking at the negatives side of it in forex trading. Most think of it as traders putting on a position too large relative to account size in the hope of scoring big on a trade (I have seen brokers offering leverage as high as 500:1) and then losing most or all of his/her capital. Over leveraging could be the result of being inexperienced, greedy or just poor money management. Whatever the case, trading with too high leverage reduces the odds of success as it makes it easy to get stopped out, even with the right idea if timing is off. Remember, if your score big using high leverage you can lose big the same way. With limited capital, preserving it to trade another day is a key to staying in the game.
This can be illustrated with an example of trading with a broker offering 100:1 leverage. Assume an initial balance of USD 2000
Example 1: (higher leverage trade)
Trade:
Buy EURUSD100,000 (USD 107,000) at 1.0700
Initial margin (1%): $1070
At EURUSD 1.0606, the account balance would be would be $1,060.60 There would be insufficient funds to cover the margin for this trade and broker would close it out. Loss = $940
The Ugly
As I explained in The Bad, the most obvious negative is when a trade is put on using too high leverage. However, this may not be the worst aspect of high leverage as it can also lead to traders hanging on to losing trades longer than would otherwise be the case. I call this the ugly because it may be more damaging to retail forex traders than the obvious one I illustrated in The Bad. .It can happen even when the initial trade is put on using lower leverage as I illustrate below.
Example 2: (lower leverage trade)
Trade:
Buy EURUSD 40,000 at 1.0700 (USD 42,800)
Initial Margin: (1%) USD 428
At EURUSD 1.03065 the account balance would be $426. There would be insufficient funds to cover the margin for this trade and broker would close it out. Loss = $1574
This is the side of high leverage not often mentioned. A trader gets caught out on a position and watches it go against him/her until the trade gets closed out. The high leverage offered by the broker gives more staying power for a trade but also more time to stay with a losing trade before getting it closed out due to lack of margin. You may say why would someone hang on to a losing position for so long. You would be surprised how many trade on hope and without risk management.
In this example, if the margin was 2% (50:1 leverage) the account would run out of available margin sooner at 1.0415 and the broker would close at the open position. Loss = $1140
This is why I call it the ugly as using lower leverage to open a trade could lead to a bigger loss than if you trade with higher leverage and get stopped out sooner. I have seen it happen too many times when traders lose discipline and either don’t use stops, override their stops or turn to hope that a loser will turn into a winner if he/she can hang on long enough.
To sum up, leverage has three sides, the good, the bad and the ugly. How traders use it determines what category their trades fall into. What you think as the obvious negative (i.e. trading too large a size) may not be the worst part of it as the cushion higher leverage offered by a broker provides can encourage those in losing trades to hang in hoping that they can recover.
Take a look at the risk management tool built-into The Amazing Trader
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