# Forex Leverage: How much should I use?

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Helping traders understand the proper use of leverage.

What is leverage? Leverage in financial trading refers to a situation where a trader borrows money in excess of his trading capital in order to execute a much larger transaction. Leverage is a double-edged sword. It can work in the trader’s favor, and also work against the trader by compounding losses.

How is leverage calculated? The formula for the calculation of leverage is as follows:

Margin leverage = total transaction value/leverage required for the transaction

Illustration

If a forex trader we shall call Brother John, requires a deposit that is equivalent to 1% of the total transaction value as his margin requirement, and he wants to trade 0.5 lots of a currency (equivalent to \$50,000), this deposit required would be \$500.

The margin-based leverage will be \$50,000/500 = 100:1.

If the margin requirement is 0.2%, the margin-based leverage will be 50,000/200 = 250:1

How This Translates to Cash in a Trading Account

In the real world of forex trading, what we consider the real leverage is calculated as follows:

So if for example, a trader has \$5000 in his account and he opens a \$20,000 position (0.1 lots), that trader is trading with a real leverage of 20,000/5,000 = 4 times leverage.

Proper Use of Leverage

Leverage can magnify a trader’s profits AND losses. The amount of risk increases with the leverage used.

Let us illustrate this again with two traders, John and Borelli, each starting with a trading capital of \$5000. John opens a trading position of 0.1 lots (4 times leverage), while Borelli decides to use 40 times leverage, or a position of 1 Standard lot.

John’s position, by virtue of his trade size, will earn or lose \$1 per pip, while Borelli’s position will earn or lose \$10 per pip.

If John suffers a 50 pip loss in a trade, he will only lose \$50, which represents only 1% of his account. This is minimal and he can easily recover this loss.

If Borelli also suffers a 50 pips loss, he will lose \$500, representing 10% of his account.

If John and Borelli suffer four more losing trades of 50 pips each, this translates into a loss of \$200 for John and an amazing \$2000 loss for Borelli, totaling \$250 and \$2500 losses respectively for John and Borelli.

5 trades down the road, and while John still has \$4,750 in his account, Borelli has lost 50% of his account size. Which of these two traders will start to panic and is more likely to make more mistakes, leading to a margin call? Your guess is as good as mine.

This illustration just goes to show how much damage an improperly managed leverage can easily go awry.

Most experts agree that total market exposure at any point in time should not exceed 5%. A leverage of 1: 100 will keep a trader within these limits because the margin commitment will reflect this on the forex charts.  Using higher leverages of 1:400 as seen on most broker websites will reduce margin commitment and tempt the trader to start over-exposing himself in the market by opening too many trades. A careless trader who does not know how leverage works will find himself in trouble repeatedly.

Look at the illustrations, learn from them and use leverage carefully.

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