Introduction

Leverage is the ability to use something small to control something big. Specific to foreign exchange (forex or FX) trading, it means you can have a small amount of capital in your account, controlling a larger amount in the market. With leverage, a little money can make a whole bunch if you are right, but leverage works two ways and losses can mount in a hurry when you are wrong. Stock traders will call this trading on margin. In forex trading, there is no interest charged on the margin used, and it doesn’t matter what kind of trader you are or what kind of credit you have. If you have an account and the broker offers margin, you can trade on it. The apparent advantage of using leverage is that you can make a considerable amount of money with only a limited amount of capital. The problem is that you can also lose a considerable amount of money trading with leverage. It all depends on how wisely you use it and how conservative your risk management is.

We summed up the useful information that will make your leverage trading effective and prevent you from making mistakes that may cost a fortune.

1. Importance Of Effective Leverage

Traders often want to ascertain the effective leverage of their trading account, along with the amount of leverage they still have available to be used in times of a potential trading opportunity. This can help manage overall trading risk and in staying below the maximum leverage limits imposed by a broker. It also helps to avoid margin calls or position closeouts, which brokers have to resort to in case of insufficient margin to support outstanding transactions.

The idea of optimizing the use of leverage is based on the goal of maximising growth of trading accounts, while not risking the total depletion of forex trading funds. Keeping an eye on effective leverage helps keep levels of trading risks visible and tolerable. Money management and risk management have been proven to be linked to each other. The Kelly criterion is an important example of this.

Kelly’s leverage optimization concept is based on the formula: L = (E-R)/ V

Here, L represents the optimal effective leverage that traders can aim for in their accounts. The term (E-R) shows the excess return of the trading strategy, where E is the rate of return and R is the risk-free interest rate. The term V is the expected statistical variance of the strategy’s excess return.

So, suppose the expected annual rate of return is 20% or 0.20, the risk-free rate of interest is 2% or 0.02, and the variance of the strategy’s excess return is 0.01, then the value of L would be:

L = (0.20-0.02)/ 0.01 = 18

This means that the trader should aim for an effective leverage ratio of 18:1. However, the Kelly criterion was designed for extremely high risk-taking traders, whereas most traders might feel comfortable with an optimal effective leverage of up to 10:1.

The forex market is popular among high volume market that commonly allows such significant leverage ratios. Equities and stocks generally won’t go above a leverage amount of 2:1. But this is because the forex market is actually far more stable than any other market; most currencies don’t fluctuate significantly the way that stocks or other forms of equity do. Thus, using leverage on the foreign exchange market is safer than using it on any other market. That being said, there are still some major concerns regarding leverage. Though these concerns don’t outweigh the benefits, they still need to be considered, especially by traders who are new to the market.

2. Low Leverage Allows trader’s to Survive

Lower leverage means risk is better controlled. In the simplest case, an unleveraged long stock position (no matter how volatile) cannot lose more than what you put in. Higher leverage on a less volatile asset may be calibrated so that your expected exposure to volatility is the same, but there is more room for unexpected volatility to wipe you out. Hence it is said that that low leverage allows traders to survive.  

3. Professional Traders and Leverage

Professional traders usually trade with very low leverage. Keeping your leverage lower protects your capital when you make trading mistakes and keeps your returns consistent. No matter what your style, remember that just because the leverage is, there does not mean you have to use it. In general, the less leverage you use, the better. It takes the experience to really know when to use leverage and when not to. 

4. Best Leverage Ratio

Forex traders need to adopt a maximum leverage depending on their risk-reward profile and trading goals. It also depends on the trader’s experience. It is best for beginners to start low. Three main factors need to be considered:

• Starting with low levels of leverage.
• Never risking more than 1% or 2% of the trading capital in each position.
• Using risk management tools like stop-loss, take-profit and trailing stops to limit downside risk.

Trading styles can have a say too. For instance, scalpers and breakout traders tend to use higher leverage ratios, since they get in and out of trades quickly, multiple times a day. On the other hand, position traders might prefer low leverage.

It is good to start with a forex demo account to test the trading strategy and leverage mixes, without risking any money.

Assets can be traded through Leverage

Leverage is used not only in the Forex market. Traders can use leverage for different assets. For example, derivative investors apply for leverage to open larger trades. Also, you can trade CFD of oil, gold, and stocks via a broker. Here, you can also use leverage. Below you will see a list of the securities that are mostly traded with leverage:

• Currencies. Of course, currencies are the most popular assets for leverage trading. Every reliable broker offers leverage for currency pairs.
• CFD. CFDs are famous among traders because they provide an option to trade such attractive assets as gold, oil, and stocks that provide a significant reward.
• Derivatives. Derivatives are also highly used by traders. Leverage allows them to operate large positions with small expenses or even without them.

Conclusion

Leverage is a progressive tool for traders to achieve good results. The obvious advantage of using leverage is that you can make a lot of money with only a limited amount of capital. However, it is impossible to choose the best leverage to use in Forex for both beginners and professional participants. This choice largely depends on the starting balance, trading strategy and the chosen risk management model.  However, one should always remember about the risks that high leverage carries.