Strategy #2 Leverage "The Killer"

STRATEGY #2: Leverage “the Killer” Most professional traders and money managers trade one standard lot for every $50,000 in their account. If they traded a mini account, this means they trade one mini lot for every $5,000 in their account. Let that sink into your head for a couple seconds. If pros trade like this, why do less experienced traders think they can succeed by trading 100K standard lots with a $2,000 account or 10K mini lots with $250? No matter what the forex brokers tell you, don’t ever open a “standard account” with just $2,000 or a “mini account” with $250. The number one reason new traders fail is not because they suck, but because they are undercapitalized from the start and don’t understand how leverage really works. Don’t set yourself up to fail. We recommend that you have at least have $100,000 of trading capital before opening a “standard account”, $10,000 for a “mini account”, or $1,000 for a “micro account”. So if you only have $60,000, open a “mini account. If you only have $8,000, open a “micro” account. If you only have $250, open a “demo account” and stick with it until you come up with the additional $750, then open a “micro account”. If you don’t remember anything else in this lesson, I plead that you at least remember what you just read above. Okay, please re-read the previous paragraph and ingrain it in your memory. Just because brokers allow you to open an account with only $250 doesn’t mean you should and I’m going to explain why. I believe most new traders who open a forex trading account with the bare minimum deposit do so because they don’t completely understand what the terms “leverage” and “margin” really are and how it affects their trading. It’s crucial that you’re fully aware and free of ignorance of the significance of trading with leverage. If you don’t have rock solid understanding of leverage and margin, I guarantee that you will blow your trading account. How Leverage Affects Transaction Costs Besides amplifying your losses, leverage also has another way of killing you. It’s a much slower kind of death, though, kind a like being constantly exposed to high levels of radiation. Most traders don’t see it coming and by the time they notice it, they’re dead. This killer I’m talking about is the associated transaction cost of using high leverage. Not only does leverage amplify your losses, it also amplifies your transaction costs as a percentage of your account. Let’s say you open a mini account with $500. You buy five mini $10k lots of GBP/USD which has a 5 pip spread. Your true leverage is 100:1 ($50,000 total mini lots / $500 account). But check this….you paid $25 in transaction costs (($1/pip x 5 pip spread) x 5 lots)). That is 5% of your account! With one trade, and the market not even moving yet, you’re already down 5%! If your trades lose, your account balance shrinks. As your account balance shrinks, your leverage increases. As your leverage increases, the faster your transaction costs eats away at the little money you have left. This is the slow and silent killer I’m talking about. The higher your leverage, the higher your transaction cost as a percentage of your trading capital. If you have a mini account, and open a trade with a 5 pip spread, which equals $5 transaction cost, look at how the relative value of your transaction costs increases with more leverage. Leverage Margin Required (MR) Cost as % MR 200:1 $50 10% 100:1 $100 5% 50:1 $200 2.5% 33:1 $330 1.5% 20:1 $500 1% 10:1 $1,000 .5% 5:1 $2,000 .25% 3:1 $3,300 .10% 1:1 $10,000 .05% Now you’ve learned how leverage can magnify your profits and losses, but also your transaction costs. Here’s a chart of how much your account balance changes if prices moves depending on your leverage. Leverage % Change in Currency % Change in Account 100:1 1% 100% 50:1 1% 50% 33:1 1% 33% 20:1 1% 20% 10:1 1% 10% 5:1 1% 5% 3:1 1% 3% 1:1 1% 1% Let’s say you bought USD/JPY and it goes up by 1% from 120.00 to 121.20. If you trade one standard $100K lot, here is how leverage would affect your return: Leverage Margin Required Return (Gain) 100:1 $1,000 +100% 50:1 $2,000 +50% 33:1 $3,300 +33% 20:1 $5,000 +20% 10:1 $10,000 +10% 5:1 $20,000 +5% 3:1 $33,000 +3% 1:1 $100,000 +1% Let’s say you bought USD/JPY and it goes down by 1% from 120.00 to 118.80. If you trade one standard $100K lot, here is how leverage would affect your return (or loss): Leverage Margin Required Return (Loss) 100:1 $1,000 -100% 50:1 $2,000 -50% 33:1 $3,300 -33% 20:1 $5,000 -20% 10:1 $10,000 -10% 5:1 $20,000 -5% 3:1 $33,000 -3% 1:1 $100,000 -1% The more leverage you use, the less “breathing room” you have for the market to move before a margin call. Leverage does not equal margin. Leverage is how many times you lever your whole account. The maximum amount that you are allowed to lever is dependent on your margin requirement. Visit: www.babypips.com for more info.