See how leverage may wipe your account clean in a hurry

Now we'll take a closer look at “leverage” and demonstrate how it routinely wipes out naïve or overconfident traders.

Allow the image below to haunt you about the bad consequences of using too much leverage and running out of margin before we begin.

We've all seen or heard advertisements for online forex brokers claiming to give 200:1 or 400:1 leverage.

We just want to be clear that they're referring to the maximum leverage you can use to trade.

Remember that the leverage ratio is determined by the broker's margin requirements. If a 1% margin is necessary, for example, you have 100:1 leverage.

There is the greatest amount of leverage. Then there's the matter of your genuine leverage.

Leverage that works

True leverage is calculated by dividing the “whole worth” of your position (also known as “notional value”) by the amount of money put in your trading account.

Let's have a look at an example:

You make a $10,000 deposit into your trading account. At a rate of $1.0000, you purchase one normal 100K of EUR/USD. Your position is worth $100,000, and your account balance is $10,000.

The true leverage is ten to one ($100,000 / $10,000).

“Effective leverage” is another term for “true leverage.”

Let's imagine you pay the same price for another ordinary lot of EUR/USD. Your position is now valued at $200,000, but your account balance is still $10,000.

Your true leverage has now increased to 20:1 ($200,000 / $10,000).

You're in a good mood, so you purchase three more ordinary quantities of EUR/USD at the same price. Your total position value is now $500,000, while your account balance remains $10,000.

You now have a 50:1 leverage ($500,000 / $10,000).

Assume a 1% margin is required by the broker.

Your account balance and equity are both $10,000, the Used Margin is $5,000, and the Usable Margin is $5,000, according to the math. Each pip is worth $10 in a normal lot.

A margin call would require a price movement of 100 pips ($5,000 Usable Margin divided by $50/pip).

This would require a 1 percent price shift in the EUR/USD, from 1.0000 to.9900.

Your account balance would be $5,000 after the margin call.

You lost $5,000, or 50% of your money, although the price barely moved 1%. That's insane.

Now if you purchased coffee from a McDonald's drive-thru, spilt it on your lap while driving, and then sued and won against McDonald's because your legs were burned and you didn't realize the coffee was hot.

To cut a long story short, instead of depositing $100,000 in your trading account, you deposit $100,000.

You only purchase one standard lot of EUR/USD at the current rate of 1.0000. Your total position value is $100,000, and your account balance is $100,000. Your ultimate leverage is one-to-one.

The following is how it appears in your trading account:

To obtain a margin call in this case, the price would have to move 9,900 pips ($99,000 Usable Margin divided by $10/pip).

This would require a change in the EUR/USD pricing from 1.0000 to.0100! This is a 99 percent or nearly 100 percent price change!

Assume you purchase 19 more standard lots at the same rate as the initial trade.

Your total position value is $2,000,000, and your account balance is $100,000. The true leverage you have is 20:1.

The price would have to move 400 pips to be “margin called” ($80,000 Usable Margin divided by ($10/pip X 20 lots)).

That means the EUR/USD pricing would have to adjust from $1.0000 to $0.9600, a 4 percent change.

This is how your account would look if you were margin called and your deal exited at the margin call price:

You'd have incurred a loss of $80,000!

An astronomical $80,000 loss!

You would have lost 80% of your money and the price would have barely moved 4%!

And you'd most likely look something like this.

Do you understand how leverage works now？!

The component of leverage in leverage increases the volatility in the relative prices of a currency pair.