Trading with Leverage: How Much is Too Much?

Trading with Leverage: How Much is Too Much?

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Trading with leverage is a concept that can be seen in many markets. This takes a unique form when it comes to the Forex market. The main reason for this is the way the market has evolved and how it has been required by the retail trading that started to proliferate since the advent of the Internet. Typically, the average price movement of a currency pair is extremely small. The change in prices are indicated by the fourth decimal place in a currency quote known as a pip and when calculated a hundred pips will equal one cent.

Historically, the Forex market was dominated by banks, financial institutions and governments with millions in investment. Although these big time players still operate in the market it has now become the retail traders’ monopoly due to easy access to trading currencies. However, the standard trading lot in the Forex market is $100,000. Since this is not the kind of money that most retail traders have at their disposal they turn to leverage.

Leverage offered generally depends on the Forex broker and the amount of the margin deposit made by the trader. The concept of leverage is to trade with borrowed money and this could be anywhere from 100:1 and go on upwards of 400:1 at times. If you make a margin deposit of $250 and are given leverage to the tune of 400:1 you will be able to trade with up to 400 times of your deposit which in this case is equal to $100,000 or one standard lot.

With leverage, you stand to gain profits that are calculated with leverage and this enables you to make substantial profits from successful trades. One drawback of the system is when you lose a trade that losses are also calculated according to the leverage that was extended to the trader. This means that you can make huge losses in the same way that large profits were possible.

Now the question arises how much leverage is too much? This is a vital point to ponder as you trade currencies in the Forex market. The Forex broker strives to ensure that you do not lose more money than you have in your account and will warn you by giving you a ‘margin call’. Whenever this situation arises the broker will ask you to increase your deposit so as to accommodate further losses if it occurs or to close the account altogether with immediate effect.  

So, as you can appreciate leverage can be loss making just as much as it is profit making. This is where you can use stop loss orders to make sure that you do not go beyond certain limits so that you can stay within the parameters set out. Learn more by reading about the history of Gann theory to understand the origins of a very popular trading strategy.

Source: www.etoro.com