When you start looking at FOREX trading, you will see a lot about leverage (also referred to as gearing). Leverage is a powerful tool for any sort of wealth building, but like any tool it carries a great deal of risk. Some FOREX brokers, including some of the most reputable ones, offer up to 400:1 leverage. What this means is that for every dollar you have in your account, you can trade up to $400 worth of currency. For a micro-lot of $1000 you only need $2.50 in your account. In addition, you keep all the profits for these trades.
The downside is that you also assume all the losses for these trades. With a micro lot's value being about $0.10 per pip, $2.50 represents 25 pips. That is not a very large margin of error for a trade. In fact, it usually represents white noise in the trading environment, which means your trade can be shut down before it ever has a chance to succeed. You do not want that to happen.
Another problem with using large leverage in trades is that if you are in one trade, you may not be able to afford to enter another good trade it it presents itself. It is always wise to have enough money in your account to safely enter one more trade, since good opportunities come and go at any time.
Finally, there is a failure rate in FOREX trading of 90% or more. A lot of the failures happen because of poor business practices, especially under capitalization. If you think of investing in FOREX the same way as investing in a traditional business, you will see that who ever is putting up the money for your trades has to get paid back in some manner. In a business it is by taking a cut of the profits. Now if you have $400 invested in your business for every $1 you have put in, how much of the profits are you going to be able to keep? These reasons are the primary ones I recommend using significantly lower leverage even when 100, 200 or even 400:1 is offered by the broker.
So, now it's time to put my money where my mouth is. If I advise lower leverage, what leverage levels do I use? 2:1 for a single trade, at most. Yes, that is a simple answer. It's also simple to figure out, although the for a single trade part is important. For now, though, let's look at the 2:1 portion.
When I started my trading account, I had a micro account and funded it with $500. This is half a micro-lot, so if I'm in a single trade, it's 2:1 leverage. Until I'm up to $1000, I will not trade two lots on a single trade. That would take me over the 2:1 ratio. When I hit $1500, I may go up to 3:1 and so on. Ideally, however, I would like to eventually bring myself to a 1:1 ratio, where I have $1000 in the account for ever micro-lot I trade. This will slow down the compounding effects, but it will also lower my risk. My plan is to do this when I am able to draw out enough money every month from my account to quit my day job while still having enough left over to grow the account. At that point I will be financially independent, and so growing the account will be a bonus and not as much a necessity.
Now, what about the importance of for a single trade? I often am in more than one trade at a time, and so my actual leverage is higher than 2:1. If I'm in ten trades at the same time, which hasn't happened to date, my leverage at that point would be 20:1. Still a far cry from the 400:1 offered. Since I don't risk more than 150 pips on a trade, if all ten lose, then I'm out 1500 pips, less than a third of my trading account. That's a pretty serious blow, but one I can recover from. If I get my single trade leverage up to 1:1, 1500 pips would be just over 10% of my account size.
So, by all means make good use of leverage in your trading. Just be aware of what leverage can do for you and don't use so much that it puts your account at serious risk. In any trading activity, risk management and mioney management are twin keys to success. Respect the power of leverage, and you'll do well.
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