Leverage can be a powerful tool for those with limited capital who want to trade larger amounts in the market, but it can also be the quickest way to break an account if used recklessly. In this article, you’ll understand how leverage works in Forex, the risks involved, and how to adjust it properly for different scenarios.
What Is Leverage?
In Forex day trading, “leverage” means trading a larger amount of money than what you have deposited with your broker. In other words, you’re “borrowing” part of this amount to increase your market position. If the trade is successful, the profit is magnified; if it’s unsuccessful, losses are also amplified.
Simplified Example
- You deposit $500 with the broker.
- You open a position worth 100,000 euros (a “full lot” in Forex).
- Essentially, you’re handling an amount far beyond the $500 you deposited.
However, this freedom isn’t unlimited: the broker requires a margin, i.e., a minimum amount on deposit to cover market movements against your position. If the price goes strongly against you, your position will be closed out (you’ll be “liquidated”) so your losses don’t exceed the deposited amount.
Understanding Margin
Margin is the amount the broker “locks in” to let you trade a larger volume. To open a 1-lot position (equivalent to 100,000 euros), you might only need $500 in margin. This means that if the market moves slightly against you and your loss nears that margin amount, the broker may close your position to avoid taking on the loss.
Trading at Margin Limits
- Higher Risk: Any adverse price movement may liquidate your account.
- Breakage Probability: With a series of losing trades, you could lose your capital extremely quickly.
Adjusting Your Lot Size
- Lower Leverage: Instead of 1 lot (100,000 euros), trade 0.1 lot (10,000 euros) or 0.01 lot (1,000 euros).
- Benefit: Your “stop” can withstand larger market moves because the required margin is lower, and the risk per pip is also smaller.
Pip, Points, and Leverage in Different Time Frames
In Forex, a pip usually refers to the fourth decimal place (for pairs like EUR/USD). For each pip the price moves in your favor (or against you), your profit (or loss) is proportional to your trading volume.
Example on a 1-Minute Chart
- Volatility: Generally smaller, in terms of pip movement.
- Technical Stop: Smaller (few pips).
- Higher Leverage: You can use more lots since the pip risk is lower.
Example on a Daily Chart
- Volatility: Larger moves in terms of pips.
- Technical Stop: Bigger, as the price can move tens or hundreds of pips against you before confirming a reversal.
- Lower Leverage: If you use 1 lot with a 100-pip stop, you may need more capital to hold the position.
Beware of Liquidation (Margin Calls)
If you open positions that are too large relative to your deposited capital, even a moderate adverse move could make your losses exceed the free margin. The broker will then liquidate your position automatically.
How to Avoid This
- Use Stop Orders: Once the trade moves against you, the stop closes it before it consumes your entire margin.
- Don’t Operate at Margin Limits: Leave some “breathing room” so you can withstand adverse moves.
- Risk Management: Set a maximum loss for each trade and never exceed that limit.
Examples of Lot Size Adjustments
- One Full Lot (1.0) on a 1-Minute Chart
- Short Stop: Only a few pips, leading to relatively small dollar losses.
- Still, Caution: If the market moves too quickly, you may lose your capital without a stop.
- 0.5 Lot on a Daily Chart
- Larger Technical Stop: 50, 100, or 150 pips…
- Margin Call: Possible if you have limited funds in your account.
- Adjust the lot size so the potential loss in pips is affordable with your balance.
- 0.01 Lot (Micro Lot)
- Each pip is worth only a few cents.
- Ideal for very small accounts or beginners.
- Allows you to learn market dynamics without risking all your capital.
Summary: Leverage Is Not a Villain, but Requires Discipline
- It’s a “Double-Edged Sword”: It boosts profits as well as losses.
- Lot Size Adjustment: Essential to match your risk to the technical stop.
- Different Time Frames: Larger time frames usually require a bigger stop, thus lower leverage.
- Stop Orders: Indispensable for leveraged trading.
Conclusion
Leverage is one of the greatest advantages—and risks—of Forex and other derivative markets. Through it, you can control much larger amounts than your balance would normally allow. However, the slightest oversight in risk management can lead to breaking your account.
To use leverage responsibly:
- Identify the Trade’s Technical Stop.
- Adjust the Lot Size so your potential loss fits within your risk limit.
- Avoid Operating at Margin Limits so you don’t get liquidated at the first market swing.
If you want to learn more about Forex and how to manage leverage, check out my free Forex mini-course. It covers everything from the basics to more advanced market concepts.
Happy trading!
-> Check out the video: