The Importance of Proper Leverage and Risk Management

Leverage is the single most valuable tool for Forex traders; it allows traders to create a lot of money using only a small initial deposit. Without leverage, Forex trading would be limited to major players like banks, hedge funds, and very wealthy private investors - the retail trading crowd would be sorely limited. With that said, leverage is also the greatest reason so many retail Forex traders lose money.

Leverage is a tool and like any other tool it can be dangerous if used improperly. A risk management plan is a necessary step for traders looking to help use leverage correctly. Managing your risk is both the most challenging and most important element of trading, so we're going to give you a little bit of guidance on how to best manage your risk to help ensure a long trading career.

Capital preservation is the key to a successful trading career. What does that mean? The money in your account, your capital, is your lifeblood as a trader. Without it, you obviously cannot trade, and the more of it you lose, the harder it is to recover. Risk management and capital preservation are two sides of the same coin; you have to manage your risk in order to preserve your capital. As corny as it may sound, trading is a marathon, not a sprint. There is no get rich quick scheme for forex, trading is about patience and hard work.

There are dozens, if not hundreds of risk management "systems" out there, some more valuable than others. All we're going to do here is show you the difference between risking 1% of your account on a trade versus 10%. Generally, a trade should risk between 1-3% of your account at most, and all your open trades should never be risking more than 3%. What that means is that if all of your open trades were to be stopped out, the damage to the overall value of your account would be 3% of less. That means you can open 1 trade that is risking 3%, 3 trades each risking 1%, 6 trades risking 0.5% each, etc.

The reason this management is necessary is simple: trading is very difficult. You will have losing streaks, it's inevitable. Losing streaks are fine, but a 5 trade losing streak, risking 10% a trade? You just halved your account. Let's take a look at some specific examples, to show you what I'm talking about.  The three scenarios I play out below all involve a 5 trade losing streak - hardly an impossible occurrence when trading forex.

As you can see from the numbers above, a five trade losing streak will virtually cut your account in half if you're risking 10% a trade, while losing 5 in a row while risking 1% will leave your account mostly intact.

The flip side of this is of course is you have a 5 trade win streak, you're account will grow much faster if you're risking 10% a trade than if you're risking 1%. The issue, however, is that forex trading is hard, and most of the time you will have more losing trades than winning trades. All it takes is one bad month to wipe out an account if you're trading at 10% risk per trade. Forex trading is about slow, consistent account growth. The best way to make money trading forex is to protect your account, protect your capital, and manage your risk.

As always, if you're having trouble managing risk, or figuring out how to best protect your account, please feel free to ask any of the strategists here at GCM inc for advice, and consider our one-one coaching program, which includes a healthy amount of risk management training.