What is leverage can I trade without it? Leverage means “borrowing” money to invest or purchase something, simply put giving you a higher buying power.
In this article, I will explain why forex leverage is important and how we can make a better use of it. Let’s say you want to buy a house but don’t have enough money.
Common sense is to go to the bank and ask for a loan. Bank will give you the loan to buy the house but you’ll be required to have 25% of the total value. Assuming the house costs $350,000 you need to have $87,500 what means is that the bank is leveraging your buying power of 3:1.
Leverage in forex is similar, to trade on a standard lot you need $100,000 so brokers are loaning you money to open that volume.
Leverage drop after regulations
I will break down for you the calculation formula for forex: number of lots X $100,000 divided by leverage. Let’s assume we have $1000 balance in our account and we want to open 1 lot with a leverage of 50:1. Applying the formula 1lot X 100,000 / 50 leverage = $2000 so not enough balance to control a lot.
How about a mini lot: 0,1lot X 100,000 / 50 leverage = $200, now you can control one mini lot. The leverage of 50 used to be the recommended one up to the new MiFID 2 by ESMA. We love margin trading and higher leverage but very few benefit from it. In a perfect world, traders will choose leverage over risk but there is a risk in everything we do.
ESMA and MiFID 2
The European Securities Market Authority (ESMA) if you're familiar with the entity, they dropped the leverage on us. Welcome to the US leverage! After so many years of high leverage in the Eurozone, the Government regulators decided to drop the leverage. In fact, it dropped out below the US leverage.
But on a serious note, I will like to talk in this article that is not the end of the trading world.
We will walk thru a simple example of how to calculate leverage and making it your useful tool. Using this example can make you achieve a proper risk management. You will understand how much money you need to open certain trades.
Not only that the risk achieved is the proper risk but in some cases, traders tend to go beyond that. If you’re one of those traders I’m sure you know what I’m talking about: higher risk – higher rewards. Whit a leverage of 30:1 or 20:1 you can still open trades and riskless. One very important aspect that 70% of traders missed out is higher balance = lesser risk.
The new leverage standards
We will be looking at GBP/USD with a balance of $1000 and a size of 10,000 (1 mini lot) and times that to 0.033. What this calculation will do is show you in percentage how much money you need to have to open a mini lot with a leverage of 30:1.
Since we are trading GBP/USD our base currency is GBP meaning that the 10,000 units (1 mini lot) are in British pounds.
Let’s get into it 10,000 X 0,033 = 330 pounds now we need to times this by the exchange rate. Today the exchange rate is 1.31 (1 sterling pound = 1.31 dollars), so we take 330 x 1.31 = $432.3. On the margin, we required $432.3 to control 1 mini lot on GBP/USD. Having a closer look at this example we understand that trading a different pair we will require less or more depending on the exchange rates.
Stop loss ratios and percentage in risk
Starting off from $432.3 to control 1 mini lot, let’s assume you have a 20 pip stop loss, which is a common stop loss used by many traders. Back to 1 mini lot and a 20 pip stop loss will look like a dollar per pip 20 pips x $1 = $20 loss if using the 2:1 reward-risk ratio. Where 2 is the take profit and 1 is the stop loss, $40 profit and $20 loss. What is $20 in percentage basis from your $1000 account balance? $1000 X 2% = $20. You can get to 2% risk very comfortably.
Think about this for a second $432.3 I wouldn’t recommend but if you multiply that by two $432.3 X 2 = $864.6 controlling 2 mini lots. Risk-wise using the same ratio 2:1 we are risking 4% = $40 loss and $80 profits. You can even go higher with 1 mini lot and a 50 pip stop loss that’s 5% risk and if you have 100 pip stop loss that’s 10% risk.
Not all Brokers are evil
Since begging on modern trading allot of retail traders lost money with unregulated brokers or investment firms. I’m afraid this will continue to happen however you have the power to avoid being scammed. Probably you’re asking why I’m mentioning scams when we’re talking about leverage right?
Well, allow me to explain: This was the intention of ESMA from the beginning, make it harder for unregulated brokers to land their services.
will have to meet those new standards and the one who don’t will cease to function. Understand that not everyone can afford trading accounts of $1000.
Having brokers giving leverage above 500:1 will seem amazing for traders that have only $100. Well, that can’t be bad right? My answer is: IT DEPENDS. If you understood the risk/reward ratio explained above its safe to agree that with higher leverage comes a higher risk. What can retail traders do with $100and a leverage of 400:1? Can he open a mini lot? YES, he can but the risk is much higher.
Concluding this exercise
The point I’m trying to make is you can still get to a proper leverage. Getting to the point where you shouldn’t be over that figure anyway.
In the event that you are over that figure then other issues are affecting your psychology such as revenge trading and others. Such issues are caused by losing a traded and many times traders associate revenge trading with doubling down. Composing yourself after a loss is key, not many follow this important rule and blame brokers or the markets.
This behaviour is kind of eliminated with leverage drop and to be honest I look at it very positive. What been said it will push traders to calculate their risk better transforming them into professional traders. Traders have to start thinking of trading as a Steady Source of Income than a Get Rich Quick Scheme.