The power of small

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Forex educators around Australia are required to start their presentations with a clear disclaimer highlighting that “forex is a leveraged instrument and you have the potential to lose more than what you start with”. But in our discussions with traders, we know that very few people understand how they can harness the power of leverage to their advantage and do it in a systematic, risk managed process, without the threat of wiping out their account.

Today we are going to uncover some of the key misconceptions around leverage and how you can use it in a sensible manner.

So what is leverage?

Leverage is used by the majority of the western world’s population in their day-to-day lives without barely a thought of the potential risk involved – I’m talking specifically about your home loan. Lenders require a small deposit of around 10% in order to secure a $500,000 home, so your $50,000 is now leveraged (10 times) and controlling a hefty half a million dollar asset. Major metropolitan house prices in Australia have continued to rise recently, so let’s say your home appreciates by 10%. At this stage your home is now worth $550,000 (albeit on paper) and you’ve made $50,000 (or 100%) on your initial $50,000 outlay. This is leverage, and the concept applies in a similar fashion when trading forex.

Leverage in the forex and CFD market

Leverage in the forex and CFD market allows you the opportunity to access larger positions with your initial capital than what you might normally be able to when trading unleveraged instruments such as stocks. Archimedes once said: “Give me a lever long enough and the fulcrum on which to place it, and I shall move the world”. Despite this potential, initially your goal is to appreciate the power of leverage, understand how it may fit in with your financial objectives and use just enough to meet your financial goals.

Leverage example on the AUDUSD

When trading forex there are three main position sizes you will need to consider when taking a position.

FX contract terminology Position size Margin required at 1%
1 Micro $1,000 position $10
1 Mini $10,000 position $100
1 Lot $100,000 position $1,000

 

Position sizes are extremely flexible and allow you to trade as little as 1 micro lot or a total position size of $1,000 (with a mere $10 held with your broker to cover the margin), which is perfect for those looking to test their strategies without risking the farm so to speak. Nothing beats live trading (as opposed to a free demo account) as the lessons learned are heightened due to real money in the game.

400 times leverage? This is not how you work out your leverage!

A common misconception we hear time and time again is that the forex market is risky because you can trade up to 400 times your account size. Many forex brokers only require you to place a 0.25% margin up front (as opposed to 1% in the table above) in order to control your full position, so trading a $100,000 position would require $250 of your own money.

The only thing that truly matters is how much your account is leveraged and how much risk you have relative to your overall account size. So let’s consider how to apply leverage on your account in a sensible fashion whilst keeping your overall risk on the account at low levels.

Here we have a hypothetical example of a system that makes or loses
5% per annum and how leverage can magnify those bottom line results.
No leverage 2 x leverage 3 x leverage 5 x leverage 10 x leverage
+5% per annum 10% 15% 25% 50%
-5% per annum -10% -15% -25% -50%

 

Broadly speaking, if you were to find a Forex, CFD or even a share trading system that achieved a 5 per cent return per annum and applied 3 times leverage, then your end-of-year return on investment (ROI) would be 15%. Similarly if the system lost 5% at 3 times leverage then you would be down 15% at the end of the year.

Out of control

So why do we occasionally hear stories in the newspaper about how leveraged products are apparently considered risky? This doesn’t seem right when:

  • The trader controls how much leverage they access
  • The trader chooses the market(s) they trade
  • The trader chooses the trade setups
  • The trader sets the stop loss levels
  • The broker simply offers a platform and leverage opportunity for traders to access.

Unfortunately we gloss over the real reasons as to how the trader got in this position, which often comes down to greed, lack of a trading plan and an expectation that trading is a sure-fire path to untold riches.

As a reader of Trader Plus you are already positioned as someone with a sound mindset and the ability to think for yourself, so here are some tips on how you can use and access leverage in a sensible fashion.

Five tips to use leverage in a responsible manner

  1. You control how much you leverage your account. The broker does not control this. Understand how much leverage you are using and maintain discipline in keeping that low.
  2. Understand how much you are risking per trade relative to your overall trading account and never risk more than 1-2% of your account on any one trade at any one time.
  3. Never over leverage, as this is the fastest way to wipe out your trading account. It is your responsibility to keep your account intact and trade within the guidelines you set in your trading plan.
  4. Pretend that every trading decision you make has to be approved by an investment panel whereby you are controlling the funds of hundreds of trading accounts. Capital preservation should be your top priority.
  5. Plan for worst case scenarios and set daily and monthly limits. Understand your daily exposure levels and be disciplined to not exceed these.

Trading the forex markets is a lot more interesting when you are trading within your limits and executing a well thought out trading plan, which will hopefully allow you to incrementally head towards your trading goals.

ashley_jessen Ashley Jessen is the author of CFDs Made Simple and Director of Communications at Invast Financial Services, one of the largest global markets brokerage firms offering Forex, CFDs, Direct Equities and their proprietary ST24 platform.

 

 

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