So you’ve heard there is a very quick way of going from $100 to $1000 and you want to try it out. You’re definitely not alone. Who doesn’t want to make a quick buck? But even though using leverage can be very appealing, remember it’s a double-edged sword: it can make you lose money as quickly and you can make it. That said, one of your first considerations if you decide to try it will be how much leverage to choose. Some trading platforms offer up to 100x leverage, how do you decide what level is right for you?
Unfortunately, there is no straightforward answer to that question, but bear with me. In this article I will cover the main things you should consider when choosing your leverage level (if you are serious about making a profit).
Decide on your risk appetite
The quick answer to picking the right leverage is: it’s up to you. Close your eyes, take a deep breath and ask yourself one question: how much risk am I comfortable with? If the thought of risking quick losses gives you cold sweats, then it is probably better to be very conservative when opting for leverage and to stick with something between 2x and 5x. On the other hand, if the money you are using is something you don’t mind risking, then you may want to go for a higher leverage.
Don’t risk more than 2% of your account balance
A common mistake beginners make is to use leverage without thinking about the size of their account balance, which could end up wiping out their whole account. We definitely don't want that happening to us, do we? So as a rule of thumb, you should always limit the capital you are leveraging to a maximum of 1% to 2% of the total capital you are trading. Here is an example:
Imagine you have $2000 in your trading account and you decide to use a 100:1 leverage. That means you would be trading with a total amount of $200,000. So a 0,1% fall in price value would lead to a 10% loss of the capital in your trading account ($200). Ouch! That’s a lot of risk.
However, if in the same situation you decide to use a more moderate leverage of 10:1, where a 0,1% fall in price would only lead to a 1% loss of the total capital in your trading account. Much more reasonable, isn’t it? And if you are using protective stops, you should be able to keep potential losses under control.
Always use protective stops
Protective stops (stop-loss and take-profit) are orders that close a position when the market passes a determined threshold. Stop-loss is a great tool for you to reduce your losses if a trade goes in the wrong direction. So if you are using leverage, you should always use stop-loss. Let me repeat that: you should ALWAYS use stop-loss when using leverage.
What a stop-loss level does is allow you to determine how much loss you are willing to take. Let’s say the price of a stock is at $100 dollars. If you set a stop-loss at $99 dollars, when the stock price hits that level you will automatically close your position, limiting your losses. That will allow you to stay in the game and keep trading, even if that one trade fails. They will also help reduce the emotion of trading and let you sleep at night knowing that there is a limit to how much you can lose. All traders eventually lose some money. But if you want to lose and live to trade another day, then learn how to use your protective stops.
Don’t go against the market
When you decide to trade a market, you can either go long (expecting a market to go up) or go short (expecting it to go down). You can also either trade with or against the market momentum. Trading with the market momentum means that you follow the trend: the market went up and you expect it to go up even more, or it went down and you expect it to go down even more. Trading against the market momentum is called mean reversion. In this case you expect that a market has fallen or risen enough, and it’s time for it to turn around (i.e. go back to its mean) now. Mean reversion with leverage is typically rather risky, because you rarely catch the exact turnaround point of the market with your trade. Your losses can mount quickly when you are leveraged and the market goes against you.
Don’t make a bad situation worse
If a situation is bad, don’t make it even worse. That is, don't attempt to turn around a losing position by adding more money and averaging down on it. In other words, do not stick to a losing position hoping for a miracle turnaround. Your trading decisions should not be made out of emotion but based on solid technical understanding. If you have followed the advice laid out above, you should be able to exit a losing position with a minor loss and try to improve your situation later with another winning position.
What leverage should you choose?
By now you have probably realized that there is no right or wrong answer when deciding on how much leverage to use. Your financial circumstances, appetite for risk and experience as a trader will all play a key role in that decision. And not all your trades will have the same leverage. You will probably decide on different levels of leverage depending on your portfolio.
If you are just starting out, you should remain conservative as you learn how to trade and gain more experience. Using protective stops and keeping positions small should allow you to start learning the proper way to manage leverage. Remember, there is no way to be 100% sure that the market will move how you expect it to, so you should always have a strategy in place to minimize your losses in case you are wrong. And if you want to learn more, you can check out our guide on trading with leverage.
