The common attractor brokers use to sell their service is their leverage offerings. The bigger their leverage offering is, the more attractive their marketing will be.
However, having a broker that offers high leverage doesn't mean you should use one. Your account size should always be considered when deciding whether to use high or low leverage.
If you use a high leverage with a small account size, leverage can wipe out your account within a minute.
Lesson Highlights
- The leverage is the buying power of traders to trade big positions using a relatively small capital.
- For small accounts, it’s advisable to use a leverage of 50:1 or lower to avoid significant risks.
- Some brokers offer the common 20:1, 50:1, and 100:1 leverage ratio. Meanwhile, some offer a 200:1, 400:1, and even a 3000:1 leverage ratio.
What Is Leverage
You've learned the different aspects of margin trading in the previous lessons. This type of trading allows you to open a position with only a small amount of money or capital.
But what gives you the power to do it? Well, it's your leverage.
Leverage is the mechanism or the buying power your broker has given you. It is expressed as the ratio, which shows the amount of money you can trade and the amount of money you really have.
If your leverage is 50:1, then you need USD 1 for every USD 50. Essentially, your broker will loan you USD 50 for every dollar you deposit.
So, if you want to open a notional position valued at USD 100,000, you need to use a margin of USD 2,000.
True Leverage
As you already know, different brokers offer different leverage, which goes up to 3000:1.
Here's what you need to know: this leverage value is not always for everyone. The example where Broker X offers 1000:1 simply means that 1000:1 is the maximum leverage you may get from its service.
But how can you know what leverage your broker would allow you?
You need to know your true leverage, also known as the effective leverage for your position. To calculate it, simply divide the position's notional value by your account equity.
Say your current equity is USD 10,000, and you want to open a standard lot of EUR/USD with a notional value of $100,000.
True Leverage= Account Equity / Position's Notional Value
True Leverage= USD 100,000 / USD 10,000
True Leverage= 10 or 10:1
Best Practices When Using Leverage
When you're leveraging your position, you can expect your position to be subject to excessive risks. If managed poorly, running at a loss will be inevitable.
Look at the most effective trading practices you must consider before leveraging.
1. Start With a Demo Account
Practicing with a demo account before diving into the live market is the best beginner advice you can get. Demo trading introduces you to the market by using a simulated environment.
You can experience the real market with a demo account without risking money. It is especially important when you're trading with leverage.
When you leverage your position, you also magnify its associated risks. If you have a huge leverage, a small market movement can destroy your account.
So, you must be familiar with the market dynamics before committing to margin trading.
2. Use Proper Risk Management
Having proper and backtested risk management techniques is the golden rule when you're in the financial market. These techniques are the first thing you must prepare if you don't want your account to be wiped out in the risky trading landscape.
Here are the best risk management techniques to implement when you leverage your trade:
Position Sizing
One thing you should avoid when you use leverage is overexposing your capital to a single risk. To effectively avoid this, you should only allocate less than 2% of your capital to one position.
This way, you don't subject all your capital to losses if the market crashes into your leveraged positions.
Setting Stop-Loss Orders
Setting up a stop-loss order for your leveraged position is important to avoid rapidly losing money. By automating the exit execution with a stop-loss order, you ensure that the account is safe from further losses, which may result in the account being wiped out.
This order also keeps you away from the emotional tendencies when margin trading.
Portfolio Diversification
Diversifying your portfolio is another effective risk management technique. It stabilizes your equity, allowing you to safeguard your investment from market volatility effectively.
In the next lesson, you'll know what to consider when choosing the leverage ratio. Remember, opting for low leverage would allow beginner traders to breathe while trading with leverage.
