Would you consider taking out a $50,000 loan against your home in order to finance a gambling trip to Las Vegas? Of course not, and yet when you leverage your Forex trades that is essentially what you are doing; borrowing money at a risk that you won’t be able to afford to pay it back.
What Does Leveraging Your Trade Mean?
On the surface, leveraging looks like a good idea. Most brokers will allow you to borrow from them to make a trade, usually with a small percentage down. Let’s say yours will require 1%. This means that for every $1,000 in your account, you potentially could trade with $10,000. Leverage has nothing to do with changing your chances of a successful trade, it just means you are able to invest more into it then what is in your Forex account.
How Can Leverage Help?
Forex trading is measured in pips, which are actually fractions of a cent. In some cases, a gain of 100 pips may only equal one dollar. For some traders, such a small return on their investment is disappointing. By increasing the amount of money they put into the trade, they are increasing the amount of profit they could gain. This will allow for them to quickly augment their Forex account.
What is the Problem With Leveraging Your Trades?
By now, the answer to that question should be clear. Not every trade is going to go the way you expect it to, and if you borrow more than you can lose you could end up not only depleting your account, but owing money on top of that. I have seen dozens of young traders who are looking to turn into millionaires overnight make this mistake. Instead of making clear cut plans and using risk management skills, they try to rely on trading large amounts of money at one time. I have seen this method fail more times than I care to remember.
It is important that you remember that the money you are using when leveraging a trade is not Monopoly money. This is what those young traders who lose everything fail to understand.
Should I Never Use Leverage?
If you use it wisely, you can take advantage of a broker’s leverage, but never at more than 5 times effective leverage. For example, let’s say that you and your partner are both looking at the same trade. You both have the same $10,000 in your account and would like to add some more to increase the profitability. If he were to leverage his 50 times while you stayed at a prudent 5 times his risk is almost twice as much as yours.
Why? On a 100 pip loss, your friend will lose half of his account, or $5,000 while you would only lose $500. Of course, had things gone the other way, your friend would have gained a substantial amount more than you, but with Forex trading earning is not about speed, it is about patience.
Leverage’s only advantage is that it gives you more options when the market is slow moving. It is easier to manage your risk to reward ratio during these times, making the probability of coming out ahead higher. During volatile times it is best to use leverage sparingly.
Does Trading Small Earn Profits?
As mentioned earlier, pips are merely fractions of a dollar. For some that type of small return can be frustrating. You should not let that deter you. Unlike stock market trading or real estate investing, FX trades are fast moving, and around the clock. This allows you to always have your money out there earning profits for you.
How Can I Make Small Trades Work?
There are three key elements to turning a small investment into a large profit:
- For one you need to manage your risk to reward. A 1 to 1 ratio is always a safe bet, but in a market that is calm you should up that to a 1 to 2 or even 1 to 3 ratio. This ensures that you will always gain more than what you potentially could lose.
- Throw your money around. With Forex trading, you have the ability to make small investments in a number of different trades at once. If you generally have a 75% success rate, then divide up your account four ways. If you managed your risk to reward ratio properly than you will show a nice profit.
- Heed your stop-loss. You made that a part of your plan for a reason. A successful trader knows to cut his small losses and run before they turn into larger ones.
Mind Over Matter
If you have a difficult time with trading small, think of your wins in terms of percentages, not pips or dollars and cents. This will help you to see how quickly your account is growing from an unbiased point of view. You must have patience with trading currencies in order to be successful at it.
While the thought of leveraging your trades and potentially increasing your profits may seem appealing, a new trader should test those waters very slowly. I have seen firsthand traders who take unnecessary risks because to them, that loan being offered by the broker is intangible money. Play it safe, take it slow and steer clear of leveraging if you have plans of making a fortune by FX trading.