I’ve been involved in a discussion recently on the topic of leverage. The question that started it all basically was “What leverage ratio should I use?” This came from a forex trader, but could certainly just as easily have come from a futures trader as well (or even a stock trader in some cases).
If you’ve ever wondered that same thing, you are asking the wrong question. Any position you take in the markets should start first with the question of how much risk you are going to take on that trade. There are a variety of different approaches to that, and I won’t get that discussion going here. For the sake of things right now, let’s just assume you’ve decided it will be $500.
Now consider the trade you are thinking about making. You should have some idea of what the point/pip risk is going to be on the trade. Translate that in to a dollar value on a per trading unit basis (contract, lot, etc.). That leaves you with three basic scenarios:
More than your acceptable risk
In this situation you find that the reasonable risk on the trade is more than what you have defined as your cut-off ($500). If that is true, there is only one course of action. Walk away. Another trade will come along. Don’t take on a trade that is riskier than what you have defined in your trading plan.
At or close to your acceptable risk
If you find that the per unit risk is close to your $500 risk target figure, put on a one unit trade. Very simple.
Below your acceptable risk
Should you discover the per unit risk for the trade you are looking at is well below your $500 limit, you can take on a bigger trade. For example, if the risk is $125/unit, do a four unit trade.
The leverage part comes in to the equation at this stage. The question becomes how much leverage do you need to use to take on the position size you have determined going through the process above.
Let’s look at things in terms of a trading unit being $100,000 in value to keep the numbers round, and that you have a $10,000 account. Throwing out the situation above where the trade risk is higher than your $500 cut-off, we are left with two situations.
In the case where the per unit risk is at or near your allowable risk, you put on the one unit trade. That means taking a $100,000 position, so you would employ 10:1 leverage. If, however, you are in the third situation where the per unit risk is $125 you can put on a four unit trade. That means a $400,000 total value trade. This is 40:1 leverage. (Note: margin requirements for forex and futures trading is often 2% or less, meaning 50:1 leverage or higher.)
Do you see how this process reverses the way you think things through?
So the real answer to the question of how much leverage to use is “the amount that allows you to trade the position size that matches your allowable per trade risk.”