In our last lesson we looked at some of the logistics of leverage on our real time demo trading accounts. In today's lesson we are going to continue our leverage discussion with a look at several examples of trades using leverage and the amplification of potential risk and reward that comes with that.
As we covered in our last lesson the real time demo trading platform which we are using, comes with a default leverage maximum of 100 to 1. What this means is that for every contract of 100,000 of the base currency that you open, you need at least $1000 of margin in your account to avoid receiving a margin call and having that trade closed.
The important thing to understand here is that this 100 to 1 leverage is the maximum offered on this particular demo account and the level at which if you drop below the open positions on your account will be closed. With this in mind it is my opinion (which was formulated from years of trading and watching other people trade) that most successful traders would never put themselves in a position where they would receive a margin call. The reason behind this is that they employ a money management strategy which controls the amount of leverage that they would use on any one trade, and for their account as a whole, something which we talk in depth about in Module 6 of our free beginner trading course in the free course section of the InformedTrades.com site.
In general most successful traders I have seen trade use a maximum leverage at any one time of 5 to 1 and many would consider even this to be too highly leveraged. The amount of leverage used really depends on trading style as much as anything as in general traders who hold positions for short periods of time and cut losses quickly are able to successfully employ higher amounts of leverage than longer term traders who need more breathing room in their trades. To help illustrate how this works from a logistical standpoint lets take a look at a couple of examples:
The best way in my opinion to think about leverage and trading on margin is to always ask yourself the question of: "By how much am I amplifying the gain or loss on my account when opening this trade?"
For this example lets say that I start trading with $100,000 simply because this is an easy round number to work through the math with.
If I open 1 contract of USD/JPY then I am trading $100,000 against the equivalent amount of JPY as we have learned in previous lessons. So if I have $100,000 in my account and I am trading $100,000 USD against JPY, then I am not leveraged as the cash balance of my account equals the position size I am trading.
With this example a 1% movement in the currency pair would represent a 1% gain or loss in the value of my account. As we learned in our last lesson the Used margin column of my account in this example would show $1000 and my Usable margin would show $99,000.
If I open 2 contracts of USD/JPY then I am trading $200,000 against the equivalent amount of JPY. As I have $100,000 in my account and $200,000 in open positions I am leveraged at 2 to 1 as the position size I am trading is twice the value of the cash in my account.
With this example a 1% move in USD/JPY currency pair would represent a 2% gain or loss in the value of my account, thus amplifying the potential gain or loss on this trade by 2 times. In this example the Used Margin Column of my account would show $2000 and my usable margin would show $98,000.
If I open 5 contracts of USD/JPY then I am trading $500,000 against the equivalent amount of JPY. As I have $100,000 in my account and $500,000 in open positions I am leveraged at 5 to 1.
With this example a 1% move in the USD/JPY currency pair would represent a 5% gain or loss on the value of my account, thus magnifying the potential gain or loss by 5 times.
For tonights homework session I recommend working through a couple of examples as I have above with other currency pairs in which the USD is the base currency in the pair. Secondly I encourage you to think about how to go about figuring out the leverage used when the USD is not the base currency in the pair.
This will be the topic of our next lesson so we hope to see you then.
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Risk Disclosure: Trading forex on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.