The currency market is full of benefits and opportunities. It’s the most liquid market in the world. Trades take place 24 hours per day, six days a week. Breaking news often inspires dramatic and potentially lucrative moves in the market. And there are many dozens of different currency pairs to trade among which you can always find a few good set-ups.

But of the many benefits of the currency market, perhaps the least understood and certainly the most misused is leverage. The fantastic amount of leverage available in the currency market is a potentially huge hazard if you don’t understand how to manage it. The fact is most new currency traders are set-up to fail from the onset of their currency trading careers. The reason: leverage!

All of the marketing literature that you read concerning currency trading touts the large amounts of leverage available. You can find 100:1 or even 200:1 at most dealers. Some currency dealers even offer up to 400:1 leverage!

Leverage

We must first understand what leverage is before trying to figure out how to effectively use it in the currency market.

Think of a lever when you’re wrapping your head around the concept of leverage. Imagine a man, his name is Bill Greenback. He’s holding a long pole at one end with the opposite end of the pole resting under an automobile. The pole sits on a pivot between Bill and the automobile. Bill is unable to even budge the automobile under normal circumstances. But he can actually lift two tires of the automobile off the ground with the benefit of the lever that he is using.

Leverage in the physical world is moving an object, usually a very large and heavy object, with proportionately less effort and energy.

Leverage in the financial world works the same way. The difference is that instead of lifting something heavy, the leverage is controlling money, in some cases a lot of money, with only a little bit of cash down.

Leverage takes many forms in the financial world, even in everyday life. In fact, a mortgage is probably the most common form of leverage that people use. A mortgage uses a small amount of money to control a proportionately huge sum of money.

How Much Is Too Much?

It just so happens that Bill Greenback is in the market for a new house. He’s 40 years old, married with two kids, and a successful software engineer who earns a nice six figure salary.

Bill is shopping for a house in the $500,000 range, and plans to put some money down to bring the monthly payment to $3,000. Bill understands that he’s getting a pretty good deal, being able to control half a million dollars with only a fraction of that sum being paid upfront. Of course Bill knows that he must eventually repay the entire amount, plus interest, and make each monthly payment on time.

Bill knows that he can easily afford the $3,000 monthly payment. His take home pay after taxes each month is $8,000, so Bill figures that he can afford the mortgage payment and still have plenty remaining each month to live a comfortable life.

Bill and his wife find a splendid 4,000 square foot house, in a nice neighborhood, with a three-car garage, and a spacious backyard all for $500,000. They think it’s a good fit.

Bill and his wife are a few days away from submitting an offer when they decide to take the family on a picnic to a nearby lake. Arriving at the destination, Bill sees a house, more like a mansion, going up for sale on the shore of the lake. The place is perfect! It’s a whopping 7,000 square feet, sports a four-car garage, and includes an in-house theater. To top it off, the giant back deck overlooks the lake.

Bill, his wife, and the kids must have it. They decide on the spot to pull the trigger and offer full asking price.

There’s only one problem: the house costs a cool million. The mortgage on the place is $6,000 a month. But the family rationalizes that it can cut back on the gift giving, take fewer vacations, drive their old cars a little longer, and eat out less often. With these cuts, Bill figures, he can afford the $6,000 a month payment. Plus, Bill remembers that he’s up for a raise this year.

The Future is Unknown

Six months after moving in, the family is happier than they have ever been. The kids make many new friends, and Bill and his wife sip a glass of wine every night on the back deck, watching the sun set over the lake.

One day on the way to work, Bill notices a strange sound coming from the engine of his sedan. He pulls over to the side of the road, pops the hood, and sees smoke billowing from somewhere below. A trip in the tow truck to the local mechanic finds Bill facing a tough decision: pay to rebuild the engine or scrap the car and buy a new one. Unfortunately, Bill’s savings account isn’t as big as it was last year, so he decides to shell out three grand to have the engine rebuilt.

The engine blowing up is not seen as a horrific event by Bill, but it does set him back about two months of salary, ex-mortgage payment. Bill figures that he can drop his cable and save $50 a month to compensate for the mishap with the car.

The stress at home builds when Bill discovers that his oldest daughter needs braces. He didn’t even consider the possibility. What’s more, because of rising health care costs, Bill’s employer doesn’t offer dental coverage. So Bill has to foot the entire cost out of pocket, and the dwindling savings account starts to weigh heavily on his mind.

Bill and his wife are starting to worry, but decide to cut back further, at least until Bill’s raise comes through at the end of the year.

Then tragedy strikes: unusually heavy rains cause the lake level to rise, flooding Bill’s basement. The clean-up costs are huge: 50 grand. Bill never even thought about the possibility of a flood. And he doesn’t know how he’s going to pay the repair costs.

After much deliberation, Bill and his wife decide to take out a second mortgage, using the proceeds to pay for the clean-up costs. Bill and his wife are banking on the raise to help payoff the second mortgage, and get back on track.

But then the seemingly impossible happens: Bill loses his job. The software company that employs Bill has seen an abrupt slump in sales, and has to layoff 25 percent of its staff. Unfortunately, Bill’s job is part of the reduction.

Bill receives a small severance of $50,000, which gets the family through six months. Bill is unable to find another job during his six months of unemployment because of the slowdown in the software industry. He decides to enter into bankruptcy and start over.

From Real Life to Trading Life

The evolution of Bill’s financial demise is not unlike the misfortune found by far too many new currency traders, who blow-up their accounts only to start over from scratch or leave the market altogether. Bill’s bankruptcy and the blow-up of a currency trader’s account are caused by the same mistake: overleveraging. It’s an easy mistake to make, especially in the currency market, where the prospects of huge profits oftentimes blind new traders to the potential perils of leverage.

The perils of leverage are losses, specifically multiple losses. Bill’s losses are in the forms of real life events like healthcare costs, natural disasters, and unemployment. Everyone faces these potential losses to varying degrees. But it’s nearly impossible to predict these future risks which, if realized, become losses. These losses, however, are manageable so long as dangerous levels of leverage are not involved.

In the currency market, seemingly random events occur all of the time. These events can catch a trader off guard and cause losses. But the losses are manageable so long as excessive amounts of leverage are not applied.

Where Bill has to deal with a broken down car, a currency trader might be caught by surprise from a central bank that decides to raise interest rates. Where Bill faces a surprise from his daughter who needs braces, a currency trader might wake up in the morning to discover that a government labor report causes a huge swing in a position. A currency trader might even face catastrophe when a country decides to devalue its currency.

There are many risks to currency traders, risks that are manageable with the appropriate amount of leverage. Some of the bigger risks include:

Devaluation
War and terrorism
Central bank rate decisions
Volatile commodities markets
Government economic reports
Burgeoning current account deficits
Political disruptions such as elections and coups

Any of these risks, or combinations of these risks, can strike at any time. These risks might even strike consecutively and in short order. They can lead to ruin if a trader is over-leveraged.

De-leverage

The defense against these risks is de-leveraging. The path to long-term survival, and ultimately profitability, in the currency market is through de-leveraging. Dialing down the leverage in your currency account will help to mitigate the many risks and keep you solvent so that you can be around for the times when making money is easy.

Forget about putting all of your account equity at risk in one single trade. Forget about worrying if you can meet a margin call or if you face liquidation. Forget about trying to earn 500 percent this year. Instead, align yourself with the reality of the currency market and start taking full advantage of all of the opportunities. Start treating the currency market as a viable investment arena. Use the appropriate amount of leverage in your currency trading and you’ll be that much closer to long-term survival and account growth.

Eric Utley is a professional trader and contributor to www.profitingwithforex.com.