And if you plan to join the ranks of the prop traders, there is one term you should learn straight away – leverage. You will probably come across it everywhere as it promises to multiply your earnings and bring you success. However, leverage is not a magic wand; it is a powerful weapon that can be used for good or evil, depending on how you master it.
So, let’s get down to basics of what is leverage trading.
How to Understand Leverage for Beginners
Leverage can simply be defined as using borrowed funds to boost your trading volume. When leveraging, you are no longer restricted by your trading account balance. The amount of money you trade with is significantly increased by your broker who lends you extra money from their reserve.
Imagine, for instance, that your broker provides you with 1:100 leverage. Then every dollar on your account becomes equal to 100 dollars. Hence, with only $1,000 on your trading account, you can trade $100,000 worth of financial instruments.
Why Prop Firms Use Leverage
Prop firms are designed to give their traders access to increased amounts of capital. This is what they offer. Upon successful passing of some sort of test or assessment, one receives an account that has funding and where the leverage plays a vital role.
The use of leverage enables one to:
- Use larger positions without having large amounts of money in one’s personal accounts
- Benefit from small price changes
- Use one’s trading strategy more effectively
However, it is important to note that losses can be increased by the same factor.
The Two Sides of Leveraging in Trading
One needs to understand the risks involved when using leverage since profits are always accompanied by equally amplified losses.
Suppose one trades with 1:100 leverage ratio and the market movement equals 1%. It would mean that a trader would lose all his capital in the game. In case it happens in a prop firm, a drawdown limit for a single day might be exceeded, resulting in a loss of a funded trading account.
For seasoned traders, leverage represents an amplification of potential risks and gains.
How Leverage Works in Prop Firm Challenges
The vast majority of prop firms impose strict guidelines: daily loss limits, maximum drawdowns, and profit goals. All three of them are closely connected with leverage.
And here is when beginners start having difficulties.
“You have a lot of leverage, therefore you will achieve your goal sooner,” you might reason. In theory, it sounds logical. The problem is that, in practice, you will reach your loss limits as soon as possible too.
That is the reason many professional traders prefer to use less leverage than the one provided by their brokers. They prioritize consistency over fast money.
The Concept of Leverage Trading Breaks Down Midway
What does leverage trading mean? It means that you are able to make trades whose size exceeds your current account balance, thanks to the loaned funds. But when talking about leveraged trading in a prop firm context, it gets a whole new meaning. You should understand that, by using leverage trading in a prop firm environment, you are actually making trades with someone else's money.
And herein lies its charm and danger at the same time.
Common Leverage Ratios You’ll See
The amount of leverage offered by different prop firms depends on the under asset:
- Forex: Typically up to 1:30 or 1:100 or even more
- Indices: Generally lesser, up to 1:10 to 1:50
- Commodities: Moderate leverage
- Cryptocurrency: Can be variable, sometimes very high
However, there's something important to note: high leverage availability doesn't necessarily mean using it in its entirety.
Properly App Leverage as a New Prop Trader
If you're a beginner prop trader, you should know that the idea isn't maximizing leverage. Your aim should be keeping risk low.
To achieve that goal, you could do the following:
Think About Position Sizing
Rather than focusing on leveraging, think about the risk. Professional traders usually risk anywhere between 0.5% to 1% per transaction despite having access to huge amounts of leverage.
Apply Stop Losses Consistently
Leveraging without a stop loss is like driving a car without breaks. It may work for a while, but you won't go far.
Don't Overtrade
The temptation when working with high leverage is making several transactions at once. That only adds more risk, making management difficult.
Adhere to Drawdowns
One of the rules in prop trading is not exceeding drawdowns.
The Psychological Side of Leverage
Not enough attention is paid to this section.
Leverage influences not only your account but also your state of mind. Higher leverage leads to higher volatility in profits and losses, which provokes emotional behavior.
You may:
- Exit trades prematurely due to fears
- Stay in unprofitable trades longer hoping for recovery
- Trade in revenge after a losing deal
You need to keep things in perspective. Think of each deal the same way despite the amount of leverage you use.
Which Is More Important? Leverage or Skill?
There is a widespread myth that leverage is crucial for being successful in prop trading. This is false.
Skill and discipline are much more important.
An experienced trader with an effective strategy and low leverage can easily beat another trader who uses leverage to trade without any strategy. In fact, most prop traders actively avoid using leverage and make small deals on purpose.
Final Thoughts
Leverage will be one of the most potent tools at your disposal when trading props – but it is also one of the most confusing.
Leverage, if applied properly, can assist in expanding your balance and achieving profits quickly and effectively. Leverage, if used poorly, can cause you to end up with no trading career at all.
So if you are new to the field, do not feel like you have to use the maximum leverage that the prop firm offers immediately.
Remember, the prop firm isn’t interested in seeing how good you can make one trade; they want to see how well you survive.
