How to choose your leverage for Forex trading?
Leverage in forex means that you are using a borrowed capital, aka margin, to increase the potential return of your investment. For example, a leverage of 300:1 means that a $1,000 order can control 300 times that amount of money, or $300,000 , in a buy/sell deal.
Leverage can be a very deadly weapon when not used wisely. Lets assume that you trade a profitable trading system and this system is having a drawdown of 5%, which is a really low drawdown for any technical trading system. When used with no leverage at all, or with leverage of 1:1, it really means that you have a 5% drawdown in your account, which is tolerable. However if you have been using a leverage of 10:1 with this same system than this means that the 5% drawdown has caused a 50% drawdown in your account (10 times 5).
If you are using a higher leverage, lets say 30:1 or more, than that same system is very likely to wipe your entire account at some point, as this is what a 0 drawdown means (30 times 5).
From time to time there are discussions of limiting Forex leverage to 10:1, at least by regulators in America, however at the moment its not uncommon for companies to let retail Forex traders use leverage of 100:1, 200:1 and even 400:1 at some FX brokerages. The known statistics is that 95% of Forex traders eventually fail, however it is very likely that most of these have used a high-leveraged accounts.
Lets see how to compute your trade with a given account leverage, and also see how much money does this left you with for your next trade.
Lets assume you are buying 100000 Euros when the price is 1 EUR = 1.35 USD. Lets also assume that you are using a 100:1 leverage.
What will be the required margin? 100000 times 1.35 times 0.01 = $1,350.00 USD. Assuming your initial account balance is $2000, can you buy more EUR after this deal?
Your account is left with $2,000 – $1,350 = $650. You can now buy more $65000 ($650 times 100) of Euros: 65000 / 1.35 = about 48,150 EUR
What is a reasonable leverage to use? From my experience I can say that a leverage of 2:1 to 5:1 is reasonable and can be used with most profitable forex robots successfully and with not-too-high-drawdowns. The exact level of leverage that you should use depends on your trading system, its profit potential vs its largest drawdown possible, or worst-case scenario. In powertrendsystem.info I have been using a 10:1 leverage successfully for over a year, with a profitable forex system on a real money account.
The bottom line is that you should be very careful as to choosing and using your leverage, as too much leverage will result in you losing your entire trading account.