Besides amplifying your losses, leverage also has another way of killing you. It's a much slower kind of death though, kinda like dying by a thousand cuts.
Most traders don't see it coming and by the time they notice it, they're DEAD.
This killer I'm talking about is the associated transaction cost of using high leverage.
Not only does leverage amplify your losses, it also amplifies your transaction costs as a percentage of your account.
Let's say you open a mini account with $500. You buy five mini $10k lots of GBP/USD which has a 5 pip spread. Your true leverage is 100:1 ($50,000 total mini lots / $500 account).
But check this....you paid $25 in transaction costs (($1/pip x 5 pip spread) x 5 lots)).
That is 5% of your account!
With one trade, and the market not even moving yet, you're already down 5%! If your trades lose, your account balance shrinks.
As your account balance shrinks, your leverage increases. As your leverage increases, the faster your transaction costs eats away at the little money you have left.
This is the slow and silent killer I'm talking about.
The higher your leverage, the higher your transaction cost as a percentage of your trading capital.
This is why transactions costs is one of the six most important factors when choosing a broker.
If you have a mini account, and open a trade with a 5-pip spread, which equals $5 transaction cost, look at how the relative value of your transaction costs increases with more leverage.
| Leverage | Margin Required | Cost as % of Margin Required |
|---|---|---|
| 200:1 | $50 | 10.00% |
| 100:1 | $100 | 5.00% |
| 50:1 | $200 | 2.50% |
| 33:1 | $330 | 1.50% |
| 20:1 | $500 | 1.00% |
| 10:1 | $1,000 | 0.50% |
| 5:1 | $2,000 | 0.25% |
| 3:1 | $3,300 | 0.10% |
| 1:1 | $10,000 | 0.05% |
Now you've learned how leverage can magnify your profits and losses, but also your transaction costs.
Leverage does not equal margin.
Leverage is how many times you lever your whole account.
The maximum amount that you are allowed to lever is dependent on your margin requirement.
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