Forex Technical vs Real Leverage

If leverage is dangerous, then using a very small one - or none - should protect a trader against any danger resulting from trading large positions, right? WRONG! This confusion is caused by a misunderstanding of the word ‘leverage’, which can have at least two different meanings.

First, leverage has a purely technical meaning and refers to the instrument offered by a broker in order to boost a trader’s power to make profit (or suffer losses). Broker X can offer a 50:1 maximum leverage for trading on its platform, while broker Y may offer a 400:1 maximum leverage.

When we are talking about leverage in its technical aspect, there is nothing wrong with using the highest leverage allowed by the broker. It is not the use of this instrument per se that places us in a risky situation, and in what follows we will explain why.

Leverage also has a more direct meaning, referring to the actual size of a trader’s position in the market. We often hear traders ask: “what leverage are you using?”. In this case, they rarely refer to the technical aspect of this instrument. What they are interested in is the effective leverage, namely to what extent the respective trader is using money that is not his own in order to boost his trading beyond the limits of his account. This is what really matters, this is the big bad wolf… Let us first give an example, then draw our conclusions.

Let’s consider 2 traders, with two similar accounts of, say, 10.000$. Trader A is trading with broker X, and has a 50:1 maximum leverage available on his platform. Trader B is trading with broker Y and has a much higher leverage available: 400:1.

We are talking in both cases about a technical leverage. Trader A decides to use only 10:1 leverage for his trades, while trader B goes for the maximum possible leverage, 400:1. Let’s assume for the sake of simplicity that both traders use a fixed amount margin: trader A will be asked to deposit 10000$ as margin for each standard lot he trades (100.000$), while trader B will be asked for only 250$ margin deposit per standard lot.

Now, both our currency traders decide to go into the market with a position of, say, 50.000$ (0.5 SL). Effectively, both of them are trading 5 times the amount of money available in their accounts, so their real leverage is the same. Technically, the situation is very different (50:1 vs 400:1 leverage), however both traders hold a similar position in the market, and each pip up and down affects them in the same way.

We can easily understand that - for equal position sizes - a higher technical leverage does NOT increase the overall risk for the trade. Moreover, there is another aspect we should take into account: trader B enjoys a slightly more favorable position than trader A, as his margin requirement is lower and thus he could hold a possibly losing position for a longer period of time before reaching a margin call than trader A.

Trader A may have thought that his 10:1 technical leverage would protect him, still he is at least as exposed to risk as trader B and he may not even be aware of that…

From the above, we can draw some interesting conclusions. It is not technical leverage that is dangerous, but the REAL leverage, corresponding to a position larger than one can afford to trade. One could trade on a very high technical leverage, and still open very small positions - which of course will still keep him on the safe side. Professionals repeat it over and over: ‘don’t use high leverage’. They refer to the REAL leverage, the size of the position, the money a trader does not have in his account.

Whether we use a higher or a lower technical leverage for our trading - that is a secondary issue. My personal advice is: use the highest technical leverage available (this will keep your unused funds to the highest level and you may even make small profits from interest earned on these funds), but ALWAYS KEEP THE REAL LEVERAGE AT THE LOWEST POSSIBLE LEVEL.

Watch carefully the size of your positions, your pip value and how much you can lose from each trade, then place this information in the context of your account. Keep your position size small, and you will be able to have a good control over your account.