Risk of Excessive Leverage

Leverage is a double-edged sword. While it has the potential to magnify
a trader ’s gains, it certainly has the potential to magnify losses as well. In
fact, the greater the leverage, the greater the risk.
Let ’s take a look at an example.
Both Trader A and Trader B open an account with a broker and start
trading with a capital of USD10,000. Trader A uses leverage of 100:1 while
Trader B uses leverage of 10:1. Both traders then decide to sell EUR/USD
because the ongoing sovereign debt crisis is putting some pressure on
the euro.
Trader A ’s total contract size is 100
×
$10,000
=
1 million. This equals to
10 standard lots. Trader B ’s total contract size is 10
×
$10,000
=
$100,000.
This equals to 1 standard lot.
For EUR/USD, we learned that 1 pip equals USD10 for one standard lot.
If the trade goes against them by 50 pips, both traders will incur these
losses:
Trader A: ( 10 lots )
×
( 50 pips )
×
( $ 10 / pip )
=
USD5,000
Trader B: ( 1 lot )
×
( 50 pips )
×
( $ 10 / pip )
=
USD500
The USD5,000 loss represents 50% of Trader A ’s trading capital, but the
USD500 loss represents just 5% of Trader B ’s trading capital.
Take a look at Table 1.3 for the summary of two traders who trade with
different leverage.
In conclusion, while leverage has the potential to magnify your profi
ts,
it also has the power to amplify your losses. It cuts both ways. After the