Improper use of leverage is considered the main cause of losses in the market. According to statistical data by the Wall Street Financial Reform and Consumer Protection Act, the majority of retail clients lose money.

This article explains the risks of using high leverage in the trading market, outlines ways to limit risk when using leverage, and guides readers to choose the appropriate level of leverage.

To learn how to trade, you need a basic knowledge of the economy and political situation of several independent countries, the impact of the macro economy on the price movements of the financial markets.

But the truth is, knowledge of global economics or finance is not what discourages novice traders. Instead, the lack of background knowledge on how to use leverage is at the heart of losing trades.

Risks of using High Leverage

Leverage is a process by which an investor borrows money to invest or buy something. In trading, capital is taken from the exchange. Trader can borrow a certain amount of this capital for initial margin, and Trader can earn more if trades well.

In the past, many brokers allowed the use of leverage ratios as high as 400:1. This means, with only $250 investment, Trader can manage $100,000 in the global trading market. However, the financial law was adjusted in 2010, according to which Traders in the US can use maximum leverage of 50:1 (still a high number), meaning that with the same $250 investment, Traders can manage $12,500.


So should newbies choose a low leverage level of 5:1 or go all the way up to 50:1 (for US customers)? Before answering this question, it is important to go through some examples of how money goes up and down with different levels of leverage.

Maximum Leverage Usage Example

Imagine trader A has an account of $10,000. He decided to use 50:1 leverage, which means he can trade up to $500,000. In the trading world, this is equal to 5 standard lots. There are three basic ways of calculating volume in trading: a standard lot (100,000 currency units), a mini lot (10,000 currency units) and a micro lot (1,000 currency units). Price movement is measured in pips. One pip move in one standard lot corresponds to 10 currency units.

Because the trader has placed 5 standard lots, each pip move corresponds to $50. If the trade goes back 50 pips, he will lose 50 pips x $50 = $2,500, which is 25% of his $10,000 account.

Example Using Lower Leverage

Consider trader B. Instead of using maximum leverage of 50:1, she chooses a lower leverage of 5:1. If trader B has a $10,000 account, she can trade up to $50,000. Each mini-lot is $10,000. In a mini-lot, each pip is worth $1. Since trader B trades 5 mini lots, each pip move corresponds to $5.

If the investment goes in the same direction as above, i.e. 50 pips, then this trader will lose 50 pips x $5 = $250, which is only 2.5% of the account.


How to choose the right Leverage

There are different ways when an investor considers leverage. The three easiest things about leverage can be done right away:
  • Maintain low leverage.
  • Use trailing stops to reduce risk and preserve capital.
  • Stop loss limit from 1% to 2% of total account for each order.
Traders should choose the level of leverage they are most comfortable with. If you are conservative and risk averse, or you are still learning how to trade, a low leverage of 5:1 or 10:1 is more suitable.

Using a trailing stop helps investors feel more secure and minimizes losing orders when the market goes against the direction. These orders are very important because they will reduce the psychological stress of trading and give each individual the motivation to get out of the trading desk.

Summary

Choosing the right leverage depends on the trader's experience, risk tolerance and comfort zone when entering the currency market. Beginner traders need to familiarize themselves with the terminology and stay in the market to learn how to trade and build experience. Using trailing stops, placing small and low risk orders is a good start to learning how to manage leverage.