On Understanding leverage, I’m going to make an experiment on how the size of the trade is related to risk. And, also, how leverage is the rope where thousands of Forex traders hang.
Most people think that if they make 1% monthly using 1 lot per trade, their return to 2% by doubling positions. And they may be right if they have a substantial account balance. That may not be the case if their account is too thin, because drawdowns are a reality in the trader’s life. So, it may happen that the account balance goes below the allowed margin.
Leverage in Forex
Leverage is the amount a trader is allowed to trade divided by their actual account balance. For example, a trader is trading one lot on the EURUSD pair on a 5,000 € account is trading 100,000,000 € against his real 5,000 € balance. Thus,
Leverage = 100,000,000/5,000 = 20
Margin
Margin is the amount required by the broker to hold a position. It’s not a cost per se. It’s only a deposit needed to hold a trade. Using the current European 30:1 leverage rule, one EURUSD lot asks for a 2,000 € margin. Thus, if the account balance happens to fall below that amount the broker must send a margin call. If not fulfilled it should close the position on behalf of the trader.
Drawdown
Drawdown is the result of a losing streak. All systems except that impossible 100% winner system have drawdowns. When using a leveraged instrument, the size of the leverage is related to the risk per position
In Forex the risk is related to the cost of a pip increment. On the EURUSD, for instance, the pip is in the 4thdecimal place. Its lot size is €100,000, therefore the pip has a value of $10 (the other side of the pair).
So, a trader trading one EURUSD lot is risking $10 per pip, while another one trading one mini-lot (0.1 lots) is risking just $1 per pip.
Working example
Let’s see it on a trader’s record. The figures below show the simulated performance of a real account during a 3-month period, while suffering a drawdown. Only the lot size has been changed.
The equity on Fig 1 was computed using a constant 0.1 lot size on an initial €5000 account which means 2:1 leverage. We can see that equity has recovered its initial balance after a max drawdown of about 2.5%. But in case the trader decided the system wasn’t good enough his worst loss would be 2.5% or 125 €.
Fig 2 shows the same segment using 1 lot size or 20:1 leverage.
Obviously, since the trade size is 10x the max drawdown went up to 25% of the maximum balance. If The trader had taken the decision to bail-out at the worst moment he would lose about 1,350 €.
Using 2 lots or 40:1 leverage only would get him a margin call. This time the drawdown would be up to 50.24%, with a minimum balance of about €2,600. But the margin call would occur sooner, when the balance went below €3000. In this case, the trader would need to sell at least one lot to keep hoping for a recovery.
And that was a 40:1 leverage. Imagine what would happen on a 500:1…
This is just to illustrate the fact that going 500:1 leverage is insane. Long before that huge drop, the trader would need to unload positions. But here we see that going from an 8,500 € peak down to 2500 € is just about ten trades. Please note that the last drop that drove the equity from 7,000 € down to 2,500 € was a tiny glitch even on the 40:1 case that happened at trade nr. 20.
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