One of the most important elements of forex trading strategies is calculating leverage. At our Forex Coffee Break Education Course, we probably talk about the leverage formula a little too much, but certainly not enough. The reason is that the ability to trade on high leverage is one of the key differences between forex trading and other kinds of trading such as stocks. And potentially one of the reasons why many traders lose money trading forex.
What is Leverage in Forex?
Leverage is the reason why you can make a ton of money in a short period of time when trading forex. It is ALSO the reason why you can get screwed over if you make a careless or uneducated decision.
Depending on your account type or the country you’re trading from you can use up to 500 times your investment. Technically, this is called 500 to 1 leverage, which is much higher than a leverage you can apply when trading stocks. In stock trading, your maximum leverage is only 2 to 1.
Leverage is a borrowed money provided by your broker which gives you the ability to control a large amount of money using none or very little of your own money.
Let’s say you have $1000 and you are trying to trade the Euro against the dollar. Here is what leverage can do to you and your money:
You first buy euro at the exchange rate EUR/USD= 1.25
You give the markets some time to move. If you fail to analyze all points of the IDDA, or simply turn unlucky, the market can move against you: The euro dropps a few pips. Now the exchange rate is EUR/USD = 1.20. If you choose to get out of the market now, this is what will happen:
You sell euro at the exchange rate EUR/USD= 1.20
Here is another example:
If you want to make a 500 thousand dollar trade, you can put in only 1000 dollars of your own, and your broker will give you the ability to control the 5 hundred-thousand dollar trade. As a result, if you make 0.2% return in your 500 thousand dollar trade, that is going to be 100% return on your own thousand dollar, right?
I know that you are now all amazed and excited and probably on your way to add a ridiculous amount of leverage to your trade, but please, first listen to me carefully when I repeat:
Leverage is a Double Edged Sword.
While you can get a significant return, leverage has the potential to bring you equally significant losses.
Leverage has another damaging habit too.Using high leverage, you will end up paying more transaction fee to your forex broker. It doesn’t look big at the beginning. It’s like buying one cigarette everyday. It’s not that expensive and it wouldn’t kill you immediately. But when you add them all together… Oh man, I don’t even want to finish the sentence.
Leverage amplifies your transaction fee that you have to pay to your forex broker.
You thought you can just borrow all this money from your broker and not get charged for it? Unfortunately brokers don’t try to act like a perfect gentleman to sweep us off our feet. They are there to make money and feed their family, and charging for a high leverage is one method for them to make money. The higher your leverage, the higher your transaction cost will be. This cost for sure differs depending on the broker and therefore it is a very important factor to check before choosing a broker.
Leverage Formula: What’s the Right Leverage for You?
Today’s question is from Gustavo Santos, who asked me: “How do I know what the right leverage is for my forex position?”
I got this question asked so many times that I decided to make yet another Q&A video to elaborate more on leverage in forex, how to calculate leverage for you forex trading strategies and a once-and-for-all leverage formula.
Using leverage shows your risk appetite. And at Invest Diva we advise that your risk per trade should always be a small percentage of your total capital. A good starting percentage could be 2 percent of your available trading capital. For example, if you have $5,000 in your account, the maximum loss allowable should be no more than $100. By analyzing the market from all points of the IDDA, you can stack the odds in your favor and then manage your risk per trade.
Managing risk per trade, is literally a combination of setting your stop and limit orders, and applying leverage. To make this calculation easy for you, at let’s introduced a magic formula we introduced at the Forex Coffee Break Education Course right here, right now.
Here it goes:
Confused? I thought so. Here is the magic leverage formula in simpler words. Basically, all you need to know is two items to come up with the best leverage for your forex strategy:
1- How much you are willing to risk losing in your specific forex trade
2- The distance between your stop loss and entry order
Voila! Then, you can insert your trade size in the final leverage formula to calculate your ideal leverage. All you need to do is dividing your acceptable trade size, by the money you have initially put into your account.
Dividing these two numbers gives you your final answer and sums up the whole “leverage Formula” shenanigans.
Got a burning trading question you need to be answered? Facebook us, Tweet us, Google us, or just come visit us in our office in NYC and ask it in person 🙂
