One of the reasons why forex trading is so appealing to CFD traders is the fact that there is generally far higher leverage available for forex traders compared to those trading other financial instruments. New, and even more experienced, CFD traders understandably like the idea that they can do forex trading with fairly low amounts of capital, effectively using other people’s money.
New traders love the idea of being able to start with very little investment. Experienced traders may have started out with trading stocks and other instruments with low leverage. They assume that if they have had some success with the low-leverage levels available to them in those markets, then they will be able to ‘scale up’ and win big at forex trading. Unfortunately, more leverage does not automatically translate to bigger profits. In fact, trading with too high a level of leverage can be the very thing that leads to bigger and faster losses.
Let us take a quick look at exactly what leverage is. Using leverage involves borrowing some of the money needed to invest in a financial instrument. Forex brokers set a maximum level of leverage, which is usually very generous. Traders themselves set the amount of leverage that they will use in their trading activities. They may choose to use maximum leverage, or they may set their available leverage much lower than the level that the broker is offering.
If a forex broker is offering leverage of up to 50:1, this means that a trader can trade with up to 50 times the amount deposited. If the trader chooses to use all that 50:1 leverage, then a deposit of £500 will allow him or her to trade up to £25,000. This can seem like a very tempting offer. The alternative to using maximum leverage is to reduce your leverage as a trader to a much lower level. If, for example, you reduce your leverage to 5:1, then that same £500 deposit would allow you to trade with just £2,500. Traders can set their leverage much lower than the maximum if they want to, but why would they want to? There are actually some very good reasons if they are aiming for long-term success at forex trading.
Most forex traders lose money in the markets, and most experts would agree that using too much leverage is one of the main reasons for this. Using too much leverage gives you the opportunity to play big and therefore lose big. At this point, new traders will be speculating that they could also win big, but successful forex traders know that trading currencies is a complicated game, and the leverage that you trade with affects not only how much capital that you have to play with but also the trading strategies that you put in place.
To understand how leverage works, it is necessary to have a basic understanding of how forex markets work and how to measure price changes. In forex trading, there are three lot sizes. A standard lot is 100,000 units of base currency, a mini lot is 10,000 units and a micro lot, is 1,000 units. Price movements are measured in pips, and each movement of one pip in a standard lot represents a change of ten units of currency.
Imagine for a moment that you are a new forex trader with £10,000 to invest. You use your maximum leverage of 50:1, giving you £500,000 to trade with. This amounts to five standard lots. With this investment, each one-pip movement represents a change (either a gain or a loss) of £50 (a £10 change for each standard lot across all five lots). If the trade goes against you, with a 50-pip move in the wrong direction, then you would lose 50 x £50, or a total of £2,500, which is 25% of the £10,000 that you invested.
So, what if you decided to invest that same £10,000 using low leverage? Say that you decide to use your leverage at 5:1. This gives you just £50,000 to invest or five mini lots. In a mini lot, a one-pip change represents just £1, so each one-pip change will result in a loss or gain of £5. When the trade goes against you by that same 50-pip change, then you would lose 50 x 5, which amounts to £250, or just 2.5% of the original £10,000 that you invested.
New traders are, of course, already speculating that the trade could have gone the other way, which is true, but all experienced traders know that forex trading, or any trading, generally involves taking a series of losses and gains over time to hopefully profit at the end of the day (for day traders), month or year. Wiping out 25% of your initial investment is hard to come back from. Losing 2.5% is nothing by comparison.
There is no easy answer to this question. Forex traders should trade with an amount of leverage that they are comfortable with. More conservative, risk-averse traders will go low. More aggressive, experienced traders will go higher. Take another look at the examples above, consider every scenario in between and decide where your comfort level is.
If you are new to forex trading, then it is always a good idea to start with low leverage. It is also advisable to limit yourself to using just 1% or 2% of your total trading capital per trade. Consider using trailing stops, or limit stops, to reduce losses when a trade goes against you, especially if you are still learning the intricacies of the forex markets and developing the discipline and emotional detachment needed by all successful traders. To learn more about managing risk, using stop losses and using leverage effectively, check out all our information on trading tips and strategies.