🎲 Introducing the Optimal Trading Leverage Formula

⚙️ Building a Simple Money Management System to Trade Derivatives

Money management (MM) is a major determinant of success when trading in any financial market. Every trading strategy we implement must align with our risk profile and long-term objectives. The way we manage our capital should always reflect both our current capabilities and future needs.

The Dilemma When Using Trading Leverage

When we identify a potentially profitable trade, we must decide how much capital we are willing to risk on that position. This is a critical decision, as larger trade sizes can lead to significant profits—but also substantial losses. Trading is a game of probabilities, not certainties, and as has often been mentioned in TradingCenter, trading leverage can be your greatest ally or your worst enemy.

The following trading leverage formula is designed to provide a simple framework for evaluating the attractiveness of each trade and, accordingly, selecting the ideal leverage ratio.

🔩 The Simple Trading Leverage Formula

Here is the formula (briefly explained below):

◘ Optimal Leverage Formula = [ (P/L) * (1/Spread) * (R/2) ] %

Where: (P/L) = Profit to Loss Ratio

Spread = the difference between the bid and ask prices (in pips)

(R) = Risk Tolerance (values 1-20)

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🔢 An Analysis of All Variables in Optimal Leverage Formula

Here is an analysis of the key variables incorporated in our simple leverage formula.

(1) Trading Leverage & Cost of the Spread

Generally speaking, leverage should be inversely related to the magnitude of trading costs. Leverage not only amplifies trading funds but also magnifies trading costs. Therefore, high leverage should be avoided when trading assets with wide spreads. Trading costs include the spread charged by the broker and may also include commissions or overnight swap charges. For simplicity, we assume all costs are incorporated into the spread.

■ Wide Spreads → Lower-Leveraged Trades

■ Narrow Spreads → Higher-Leveraged Trades

(2) Trading Leverage & the Distance to Stop-Loss

The distance between the current price and the stop-loss level largely determines the appropriate leverage. In general, leverage should be inversely related to the distance to the stop-loss.

■ Wide Distance Between Current Price & Stop-Loss → Lower-Leveraged Trades

■ Narrow Distance Between Current Price & Stop-Loss → Higher-Leveraged Trades

(3) Trading Leverage & Profit/Loss Ratio

◘ Profit/Loss = Potential Gain (Pips) / Potential Loss (Pips)

The Profit/Loss Ratio is a simple measure of a trade’s attractiveness. The profit potential is the distance between the current price and the take-profit level. The loss potential is the distance between the current price and the stop-loss level.

As a rule of thumb, a P/L ratio above 2 (P/L > 2) indicates a potentially profitable trade.

■ Higher Profit/Loss Ratio → Higher-Leveraged Trades

■ Lower Profit/Loss Ratio → Lower-Leveraged Trades

(4) Trading Leverage & Risk Tolerance

Risk tolerance should consider each trader’s needs, expectations, experience, and past performance. Alternatively, it may reflect the historical performance of specific asset categories or individual trading instruments. For example, a Forex trader may have an average gain of +30 pips when trading EURUSD, but an average loss of -10 pips when trading USDJPY. Clearly, the past performance of each asset should influence the risk tolerance applied to future trades.

■ Positive Past Performance → Higher-Leveraged Trades

■ Negative Past Performance → Lower-Leveraged Trades

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🔰 Basic Principles for Determining the Optimal Trading Leverage Rate

Considering all the factors discussed above, we can establish some basic principles for determining the optimal leverage rate. Trading leverage should be balanced and optimized based on:

1 → The Spread Charged (the higher the spread, the lower the leverage)

2 → The Nearest Key Support Level (the closer the support level, the higher the leverage)

3 → The Nearest Key Resistance Level (the closer the resistance level, the lower the leverage)

4 → The Profit/Loss Ratio of the Trade (the higher the P/L, the higher the leverage)

5 → The Past Average Performance of Assets and/or Asset Classes (the better the past performance, the higher the leverage)

Formulating the Above Assumptions

By combining these assumptions, we arrive at the following formula:

◘ Leverage Formula: Optimal Leverage Rate = [ (P/L) * (1/Spread) * (R/2) ] %

This provides a simple method to calculate the optimal or maximum trading leverage level for each trade.

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📝 Examples Using the Optimal Trading Leverage Formula

Here are some examples for educational purposes.

Assumptions:

• Risk tolerance is medium (R = 10, max=20)
• All charges are incorporated into the spread paid

👉 Example-1:

• If P/L = 3 (which is good) and Spread = 0.5 pip (also good), the formula indicates (max) leverage up to 60:1 (indicating a very good trade).

🧮 Calculations: {(3) * (1/0.5) * (20/2)} = 60

👉 Example-2:

• In another example, if P/L = 1.5 and Spread = 2 pips, the formula indicates (max) leverage of about 7.5:1 (indicating a less favorable trade).

🧮 Calculations: {(1.5) * (1/2) * (20/2)} = 7.5

👉 Example-3:

• In a further example, if P/L = 0.8 and Spread = 8 pips without commissions, the formula indicates (max) leverage of 1:1 (meaning it is better not to execute that trade).

🧮 Calculations: {(0.8) * (1/8) * (20/2)} = 1

📌 Note:  As can be understood from the examples above, if the formula suggests a low-leverage trade, it is generally better to avoid trading that position using derivative products.

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🏁 Final Verdict Regarding Trading Leverage

As mentioned at the beginning, trading is a game of probabilities, not certainties, and in this context, trading leverage can be your greatest ally or your worst enemy. Professional traders generally use tight leverage, especially during choppy market conditions. Conversely, retail traders often use high leverage (>50:1), which helps explain why, on average, they lose their accounts within six months.

One major issue retail traders often underestimate is that trading leverage increases not only your risk but also your trading costs. Never forget to account for trading costs before opening any trade position.

• Trading leverage increases both trading risk and trading costs
• The way we manage our capital should always reflect both our current capabilities and future needs

The fact that you pay more when increasing leverage explains why Forex brokers heavily advertise high leverage. Every middleman profits more when clients open highly leveraged positions.

• Forex trading is a business where every middleman earns money from your trading costs

Regarding the leverage formula introduced in this article, more parameters could be added to better capture the unique characteristics of each trading asset. However, the decision was made to keep things simple. For day traders who need to make decisions in seconds, this formula can be especially useful. Additionally, developers of automated trading systems may use it to filter and optimize their trading decisions.

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■ Introducing the Optimal Trading Leverage Formula: Mastering Risk

Giorgos Protonotarios, Financial Analyst,

for Trading Center (c), 29th of June 2013 -Revised July 2025