Leverage is one of the most important instruments in trading, as it allows a trader to dispose of more funds than he actually has, thus boosting his trading power and allowing for profits and/or losses up to 400 times higher. It is obvious that this enormous power can make the heaven or hell of any trader. Lowering the leverage used is certainly one way of reducing the inherent risks related to trading, however as we will see below lowering the leverage is just one side of the coin... There is more to risk management than simply lowering the leverage, and the key aspect is entirely different: lower leverage must result in a smaller trading unit size in order to protect effectively the trader from high volatility. Otherwise, a small leverage would only create an illusion of safer trading.

It is very important to understand that our use of technically high leverage is only intented to keep our options open and allow for possible protective measures (like hedging). We do not use high leverage in order to boost our positions beyond what we consider to be a reasonable level of exposure. We learned from past experience that it is not exclusively the leverage that induces large drawdowns and losses, but rather the use of trading units too large in relation with the account's available margin.

DON'T GET STUCK IN THE WORD and its usual technical meaning: leverage may refer to 2 entirely different aspects of the same thing, at the same time. This is why we must draw an essential distinction:

  technical leverage = it is an instrument that can be used by the trader (and given by the broker) in order to reduce the amount of margin required for a trade - this is the leverage we use to the fullest possible extent. We do not hesitate to use 400:1, if available, but we still keep our positions small.
  effective leverage = it is the actual number by which a trader effectively boosts his trading power beyond the limits of the account. This is where the position size is paramount... This is the REAL leverage, the Big Bad Wolf, the one we all try to avoid but cannot do without.

Negative example: Somebody trades 1 Standard Lot (100.000) on a 1000 USD account with 250 USD fixed margin and 400:1 technical leverage. This means that the trader uses at least 100:1 effective leverage (100.000=1000X100), which of course (to us) sounds more like blackjack than serious trading... A simple -75 pips market fluctuation will trigger a margin call and a 75% account drawdown - a scenario which on FOREX can easily turn into a real nightmare in a matter of seconds! Please, don't try this at home. Don't try it anywhere for that matter...

We never use more than a cumulated 6:1 effective leverage, and we rarely reach this limit.

Let us imagine that we are using a broker which requires a margin based on a fixed-dollar amount. In this case, the actual position size will be:

Position size = required margin X leverage used

For example, we may trade a 50.000 USD account with a huge 400:1 technical leverage, however even if our remaining margin allows for significantly bigger positions we will still use our small lots (30.000 per entry):

  Scenario nr. 1: 30.000 = 400 (leverage) X 75 (margin used for each entry)

Alternatively (scenario 2), we could use a much smaller 50:1 technical leverage and instead trade lots three times as big (90.000 per entry, of course on a margin deposit which will result proportionally higher):

  Scenario nr. 2: 90.000 = 50 (leverage) X 3600 (margin used for each entry)

In both cases, we would be able to enter the market and have up to 10 such positions open at the same time. There would still be some margin available... However, it is obvious that the risk exposure is double in this latter case, even if the technical leverage being used is 8 times smaller than in our first scenario (which should theoretically create a safer context). This is a natural consequence of a pip value three times as big (if in our first scenario a pip valued 3 USD, in our second scenario each pip won or lost would effectively value 9 USD, which means the risk of loss is triple and our maximum drawdown limit would be reached three times as fast).

Besides the fundamental difference of the trading units, the only other notable difference between the two cases featured above is the amount of margin funds required by our broker to hold a position. In the first case (required margin=75 USD), as the leverage is 8 times higher than in the second case (required margin=3600 USD), the margin we need to deposit with our broker is 48 times smaller (as the rest of the funds will be provided by the broker as an "invisible" temporary loan). In the process of trading, the amount of used margin is less important, as it is the trading unit size that will eventually result in a bigger profit or loss. However, even if we work on very strict unit size rules, we believe that having more funds to dispose of as margin (if needed) is preferable to keeping larger amounts of money blocked into an open position (which in the case the broker offers positive interest for unused funds can create additional small profits as well). In the first case, if 10 positions are open at the same time this will require 10 X 75 = 750 USD as margin from our 50.000 USD account, which leaves us with a total of 49.250 USD unused funds = 98.5% of the account balance. In the second case, we will need 10 X 3600 = 36.000 USD as margin requirement, which leaves us with only 14.000 USD unused funds in our account = 28% of our account balance (actual profits or losses resulted from trading are of course excluded in both cases).

In a nutshell, our approach is this: if we can use high leverage, we use it to the fullest possible extent. Nevertheless, our rules with regard to trading units stay the same and will be respected regardless of how sure we may be of the outcome of a certain trade.

Money Management / Understanding Leverage