Leverage Amplifies Gains and Losses — and Expectations - dummies

Leverage Amplifies Gains and Losses — and Expectations

By Kathleen Brooks, Brian Dolan

Leverage refers to the multiple applied to your available margin collateral, which translates into the maximum size of your market position. Leverage is typically expressed as a multiplier rate (like 10 times or 20 times) or a ratio (like 10:1 or 20:1). If the leverage rate is 10-times/ratio is 10:1, for example, and you have $1,000 of available margin, you’re able to hold a maximum position equal to $10,000.

Online currency trading firms typically offer higher leverage ratios than you may be familiar with from trading stocks on margin. Leverage ratios among currency brokers are typically on the order of 100:1 for standard-size accounts (100,000 trade-lot size) and 200:1 for mini-accounts (10,000 trade-lot size).

Recent regulatory changes around the world have limited maximum leverage ratios to lower levels, such as 20:1 in Hong Kong or 50:1 in the United States, which is more than sufficient for individual traders.

Be wary of forex brokerage firms that offer super-sized leverage. Some offerings are up to 400-times leverage, or 400:1. You are strongly discouraged from employing that much leverage. As well, regulatory limits on leverage have seen some traders go jurisdiction shopping, looking for the highest leverage available, but ending up in dodgy locales that may carry additional risks.

Leverage is a great trading tool, allowing traders with less capital to participate in markets that they couldn’t trade otherwise. But leverage is still just a tool. As with any other tool (think of a chainsaw here), if you learn how to use it properly, you’ll be able to get the job done faster and easier. But if you don’t learn how it works, and respect it, you’re asking for trouble.

Most people see only the upside benefits of leverage — the larger the position on a profitable trade, the larger the profit, right? Yes, leverage will magnify your gains, but it’ll also magnify your losses — the larger the position on a losing trade, the larger the loss you’ll experience. You need to have a healthy respect for the downside risk in trading, or you won’t last very long.

Take an example of a $100,000/lot-size account with $10,000 in initial margin deposited at a 50:1 leverage ratio. That margin balance translates into a maximum position size of $500,000, or five lots. If you were to take a position in USD/JPY at 90.00 using the maximum position size available, every pip change in USD/JPY is worth about $55.55 ([$500,000 x 0.01 pips] / 90.00 = $55.55).

But USD/JPY is regularly subject to 50- to 100-pip price swings in a single day (or more). If you’re positioned the wrong way, you could lose around $2,778 to $5,555 in the course of a normal, run-of-the-mill trading day. That’s about 28 percent to 55 percent of your trading capital in just one trade!

The key here is to avoid being seduced by leverage. Just because you’re able to get 100:1 leverage doesn’t mean you have to use it all. Trading a larger position may seem sexy, but no one ever said prudent, risk-aware trading was supposed to be sexy. Use leverage as a tool to facilitate your trading strategies, not as an ego booster.