I Frequent several forex trading message boards and often see questions like the following from individuals who are just getting into Forex:

My broker only allows me to trade with leverage as low as 10:1.  I don't want to risk that much - can I somehow set it to 1:1?

This type of question reveals a misunderstanding of leverage that many new traders have.  Leverage does not equate to risk.  It simply dictates the largest size of a position or positions a trader can take.

I came across a clear and simple explanation about the difference between these two concepts tonight in an article entitled What leverage is really all about, written by John Forman at The Essentials of Trading.  Since I couldn't improve on the author's explanation if I tried, I've copied an excerpt below (emphasis mine):

Allowable leverage tells you one thing - how big you can trade, either in terms of position size or number of positions. That’s it. No more. No less.

Risk comes down to one thing, and one thing only - the size of your position. The larger the position, the greater the risk. It’s that simple, really. High degrees of available leverage certainly allow for larger positions, but they do no require them.

The thing that I think causes the most confusion is thinking in terms of margin and not account size. If you trade at 100:1 leverage you would have to put up 1% margin. That means a 1% move in the market against you would wipe out your margin deposit. If you were trading on 50:1 leverage the same 1% move against your trade would only take out half your margin. That seems like less risk.

Here’s why it isn’t.

Assume a $10,000 account and a $100,000 trade size. For a 100:1 leverage account the margin requirement would be $1000, while at 50:1 it would be $2000. If the market moves against the position by 1%, that would mean a $1000 loss to the account, or a 10% decline in account value. It doesn’t matter whethere the trade was done in a 100:1 or 50:1 leverage account. A 1% move on a $100,000 position will always represent a 10% change in account value for a $10,000 account.

The only time differences in leverage mean differences in risk is when you are talking about different position sizes, basically meaning using all available funds for margin. The 100:1 leverage $10,000 account could trake $1 million, while the 50:1 could only go as high as $500,000. Clearly, when the accounts are maxed out like that a 1% move in position value is different. The 100:1 account would be wiped out, while the 50:1 account would only lose have its value.

So, assuming a constant position size, a trader does not necessarily risk more by using higher leverage.  Higher leverage just means that the trader can take a larger position or more positions if he/she so chooses.  Hopefully this will help clear up this mystery for some.

 

USD/CAD is hanging around a rising trendline that has served as support for the pair in the past. The daily chart below shows the trend beginning in early November last year, with it testing the trend line in February and a couple of times in March, and now again for the second time in April. I'm going to put a buy limit order ten pips above today's high. I like these kind of setups because they're low-risk, since the logical place for my stop is just below the trendline. In this case, my stop will be ten pips below Thursday's low. Most times that I can catch a currency pair reversing at a point of support or resistance, I will look for a low-risk entry on a break the opposite way, with my stop just beyond the area of support or resistance. I prefer this to trying to catch a breakout, because I can use a stop that's closer to my entry.

I should probably clarify what I mean by "low-risk" in this case. I size my positions relative to how far my initial stop is from my entry point. So I'll risk the same amount of my account on a trade where my initial stop is 300 pips away from my entry versus a trade where my initial stop is only 100 pips away; I'll just use a smaller position on the trade with the 300 point stop. So, technically, all of my trades carry roughly the same amount of risk. This particular trade is a "low-risk" trade for me in the sense that since my profit targets are multiples of R (my initial risk), if my initial risk is a small amount of pips, then the currency pair doesn't have to travel as far in my direction for my profit targets to be hit as it would if my initial risk was larger.  So, with that said, we'll see what happens on this one.

• Order = Buy Limit
• Limit Price = 1.01048 (10 pips below today's low)
• Stop Loss = 0.99780 (10 pips above recent high)
• 1st Profit Target = 1.01682 (1/2R)
• 2nd Profit Target = 1.02316 (1R)
• 3rd Profit Target = Let it ride

Also, by the way, not much action today on the other pairs I watch, except for GBP/USD which dropped like a rock back to the trendline that it broke out of last Thursday.