How can foreign exchange traders choose their leverage ratio reasonably?

The importance of leverage is often overlooked when it comes to managing foreign exchange trading risks. Traders need to think about how to choose the right leverage to ensure long-term stable returns on their trades. Although the trading leverage available in the market may be high, this does not mean that the maximum leverage must be used at all times.

With a business degree, Mitchell has been trading in multiple markets since 2005 and educating traders. His articles have been widely published and he is a member of the Canadian Association of Market Technical Analysts. He is the author of the e-book The Day and Short-Term Trader's Guide to Forex Strategies, which introduces readers to Forex basics, practical tips, and price action trading strategies.

partbrokerOffering leverage of up to 500:1, "how much leverage to use" is a common question asked by many traders, especially novice traders. Most participants understand that leverage is a double-edged sword that amplifies both profits and losses. Choosing the right leverage depends on the size of the account and the type of trade. But before that, we should establish some basic money management principles.

Capital management and leveraging

The amount at risk for a single trade should generally not exceed 1% of the total capital. Risk here refers to the difference between the bid price and the stop price, which is magnified by the size of the position. For example, let's say you buy EUR/USD at 1.30, set the stop loss at 1.29, and the spread is 100 basis points. 1 standard lot of EUR/USD changes in value per basis point of about $10, 1 mini lot is about $1, and 1 micro lot is about $0.1. Therefore, the risk of trading 1 standard lot is $1,000, 1 mini lot is $100, and 1 micro lot is $10. If you trade multiple lots, the risk is multiplied accordingly.

Adhere to the principle that the risk does not exceed 1% of the principal. In the above example, if the risk of the transaction is $1000, the account funds must be at least $100,000. If the risk is $100, the account should be at least $10,000; if the risk is $10, the account size needs to be at least $1000.

According to these management guidelines, we can further consider how much leverage should be used depending on the account size and trading style.

How to Determine Foreign Exchange Leverage

The most straightforward way to understand leverage is through examples, and the following will demonstrate the reasonable choice of leverage under different account sizes and transaction types.

10,000 USD Account - Short Term Trader

For a $10,000 account, the trader can take a single risk of $100. If a trade has a risk spread of 300 basis points, then the trader can operate 3 micro lots with a risk of about $90. There is no need to use leverage at this time, because the trade amount is only $3,000, which is much less than the total account value.

If the stop loss spread is 75 basis points, the risk tolerance is still $100, at which point you can trade 1 mini lot and 3 mini lots, with a total risk of about $97.50. The total value of these 1.3 mini lots is about $13,000, and the account is only $10,000, so leverage is required. In this case, at least 2:1 leverage is required to be able to operate a position worth $20,000, which is enough to cover a $13,000 trade.

Holding multiple positions at the same time may require higher leverage, such as 5:1 or 10:1. Since the stop loss setting for each trade may be different, it is safer to reserve slightly higher leverage than insufficient leverage. But even if higher leverage is available, it is not necessary.

10,000 USD Account - Day Trader

Since the EUR/USD intraday volatility is usually between 90 and 130 basis points, the risk spread of a single trade for intraday traders is often controlled at 10-20 basis points. Keeping a single loss below 1% of the account value, if the risk is 20 basis points, the trader can operate 50 micro lots or 5 mini lots, which corresponds to a risk of about $100.

5 mini lots are worth $50,000, so leverage must be used. Because of proper risk control, leverage becomes an important tool in such strategies. Traders are likely to open multiple similar positions at the same time. Holding two of these positions requires about $150,000 of capital in the market, so at least 15:1 leverage is required, and sometimes 30:1 or 50:1 may be used. Beyond this range is rarely used.

If the account size is larger or smaller, the same principle can be followed.

$5000 Account - Scalper Trader

Following the principle that the risk does not exceed 1% of the principal, the trader can take a risk of $50 per trade. Scalping trades usually have small risk spreads, assuming 10 pips of risk per trade. This means that in EUR/USD trading, 5 mini lots can be operated. If you lose 10 basis points, the loss is $50, or 1% of the account funds.

The cost of 5 mini lots is $50,000, so 10:1 leverage is required to make this trade. The same logic applies when multiple trades are made at the same time. If you build 3 positions at a time and need to deploy 150,000 dollars, you need at least 30:1 leverage. Using 50:1 leverage allows for a buffer, but this high ratio is usually only required when holding multiple positions. If you only make one trade at a time, then 15:1 or 20:1 leverage is sufficient.

Why do brokers offer high leverage?

Forex brokers offer leverage of up to 500:1 for a simple reason: to attract traders, especially to make some people mistakenly believe that they can quickly make high profits with very little money. For example, trading 1 micro lot of EUR/USD costs about $1,000, and 1 mini lot costs $10,000. Therefore, opening an account usually requires a certain capital threshold, which makes it necessary for many traders to use leverage to establish a minimum position. Many novice traders tend to have overly optimistic expectations and take risks of much more than 1% of their principal, and high leverage provides the conditions for this. Extremely high leverage can easily lead to the illusion of getting rich quickly, but in reality this rarely happens.

Summary - How to Choose the Right Foreign Exchange Leverage

Using the examples above, you can work out the leverage ratio you need based on your account size and trading style. Many traders may find that they do not actually need a lot of leverage, but it is still beneficial to have the amount of leverage available. The key is that even if an account offers high leverage, it does not need to be used in full. Market opportunities are always there, and there is no need to take too much risk or use too much leverage on a single trade. 50:1 leverage is already too high for most traders, and a ratio of around 20:1 is more suitable for most day and short-term traders. Forex trading is inherently risky, and using too much leverage can not only lead to significant losses, but also lead to liquidation. By insisting on limiting the risk of each trade to less than 1% of the capital, traders often find that they do not need the extremely high leverage offered by brokers.

This article was written by Cory Mitchell, a proprietary trader and licensed market technical analyst, and focuses on short- to medium-term technical strategy analysis.