Overleveraging in Forex Trading

Many of us are not clear what overleverage is in forex trading? You are fooled into thinking that it is a good thing to control $200,000 with $1000. Forex brokers constantly extol the virtue of 200:1 leverage ratio. Don’t fall into this trap. Overleverage is like driving at a speed of 150 mph. Suppose you have $1000 starting balance. You decide on a leverage of 200:1. A mere 10 pips move against you would result into 20% of your account equity getting wiped out if you were to trade $200,000 in EUR/USD.

This is not the only thing. In any trade there is a trading cost. Trading cost is the bid/offer pips spreads you pay when enter the trade or exit the trade. Suppose the spread is only 3 pips. In fact, you are having a trading cost of $60 just by entering the trade and you are down 6% on a trade. $60 trading cost on $1000 equity is not a small thing. This is only the entry cost. If you are forced to exit, you will again have to pay $60 as the trading cost. Your total trading cost will become $120. This is much more than any permissible loss. Any market noise is bound to wipe out your account size. Trading position sizes this big in relation to your account size means that you are essentially trading yourself into a corner.

You may as well hand over your money directly to your forex broker instead of losing it in a trade if you are overleveraging your trades. Forex brokers love this. This is easy money for them. What is the suitable level of leverage for a retail trader? The retail investor should definitely not use more than 10 times leverage. It means the price would have to move 1000 pips against you before your account gets wiped out if you have a starting balance of $1000. Professional money managers don’t use more than 2-5 times leverage level.

Understanding the role of leverage and how to avoid overleverage is crucial for your long term success as a forex trader or for that matter any trader. You get more room to maneuver and it gives you more flexibility with a leverage level of 10. Choosing the right amount of leverage is the first critical step in maintaining your flexibility in the market. Learn to be flexible when trading. Flexibility is critical for you if you want to survive in the forex market long term. Flexibility in trading means giving you options. Options to enter into a trade! Stay in it and get out of it.

Trade only one big lot and you essentially remove options from your table until you are faced with an all or nothing trade by becoming overexposed to any one position. Your survival is measured in days not years in the forex world. Never ever trade without a stop loss in place! This is the most important risk management lesson. However, most of the time you will get stopped out of the market too soon! Most traders have had the frustrating experience of getting stopped out. Only to see the market return back to your entry point some times later on in the day. The only way to stay out of such situations is to stay flexible and trade multiple lots.