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Failing to manage Forex leverage is one of the biggest pitfalls currency traders face. While trading with leverage can significantly enhance returns, it also increases the risk of big losses when a trade fails. The currency market allows traders leverage of as much as 400:1, meaning that for every $1 in your trading account, you can trade $400 using borrowed money.
However, most traders generally use much smaller leverage of around 2:1, meaning that if they have $50,000 in their trading account, they can make trades of as much as a total of $100,000.
If you are not sure of how much leverage you are currently using on your trading account, here is a simple formula for computing it: take the amount of your total open positions and then divide by the amount of money in your trading account. Thus, if your open positions are worth $60,000 and you have $10,000 in your trading account, your effective leverage is 6.
Now that you know how much leverage you are using, you can determine if it is appropriate for your trading style. If you are an aggressive trader with a high risk tolerance, you can trade using leverage of as much as 10:1. On the other hand, if you are more conservative, you might want to consider using leverage of just 2:1 or 3:1.
Generally, most brokers advise traders to use less leverage rather than more, simply because a few losing trades can easily wipe out your trading account, leading to a margin call or the loss of your positions.
For example, if you have $10,000 in your trading account and you use 100:1 leverage to trade 10 mini-lots worth $10,000 or $1,000,000 in all, a 100 pip loss will cost you $10,000 or wipe out your trading account.
On the other hand, if you use leverage of just 10:1, you can trade just 5 mini-lots or $100,000, and a similar loss will cost you just $5,000, which will still leave $5,000 in your account.
Another reason why you might want to use less leverage is to reduce your transaction fees. For example, if your trade has a five pip spread, your transaction cost will be around $500 or some 5% of your trading account.
This means that even before you've made a profit on your trade, you already have to make up the $500. The higher the leverage you use, the higher your transaction cost, and vice-versa.
(Content credit: http://www.mtrading.ng )
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