Risk of excessive leverage

Leverage can magnify your profits or losses by the same magnitude. Let's look at it using an example.

Consider two traders A and B who have the same trading capital of $10,000 in their trading accounts. Their accounts are with the same broker and have the same type of account. Consider the situation where both of them plan to short trade USD/JPY at 120. However, they use different leverage.

Trader A takes the 1:50 (50 times) leverage on this trade by shorting/selling US $500,000 worth of USD/JPY (50 x $10,000) based on his $10,000 trading capital. Because USD/JPY stands at 120, one pip of USD/JPY for one standard lot is worth approximately US $8.30, so one pip of USD/JPY for five standard lots is worth approximately US $41.50. If USD/JPY rises to 121, Trader A will lose 100 pips on this trade, which is equivalent to a loss of US $4,150. This single loss will wipe out 41.5% of his total trading capital.

Trader B is a conservative trader who decides to use (1:5) five times leverage on this trade by shorting/selling US $50,000 worth of USD/JPY (5 x $10,000) based on his $10,000 trading capital. That $50,000 worth of USD/JPY equals to just one-half of 1 standard lot. If USD/JPY rises to 121, Trader B will lose 100 pips on this trade, which is equivalent to a loss of $415. This single loss costs him just 4.15% of his total trading capital.

The chart below summarizes the impact of the trade on their final account balance after losing 100 pips.


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