Sunday, August 28, 2011

More on Leverage

Here's a chart of how much your account balance changes if prices moves depending on your leverage.

Leverage% Change in Currency Pair% Change in Account

Let's say you bought USD/JPY and it goes up by 1% from 120.00 to 121.20. If you trade one standard $100K lot, here is how leverage would affect your return:

LeverageMargin Required% Change in Account

Let's say you bought USD/JPY and it goes down by 1% from 120.00 to 118.80. If you trade one standard $100K lot, here is how leverage would affect your return (or loss):

LeverageMargin Required% Change in Account

The more leverage you use, the less "breathing room" you have for the market to move before a margin call.
You're probably thinking, "I'm a day trader, I don't need no stinkin' breathing room. I only use 20-30 pip stop losses."
Okay, let's take a look:

Example #1
You open a mini account with $500 which trades $10K mini lots and only requires .5% margin.
You buy 2 mini lots of EUR/USD. Your true leverage is 40:1 ($20,000 / $500). You place a 30-pip stop loss and it gets triggered. Your loss is $60 ($1/pip x 2 lots).

You've just lost 12% of your account ($60 loss / $500 account). Your account balance is now $440.
You believe you just had a bad day. The next day, you're feeling good and want to recoup yesterday losses, so you decide to double up and you buy 4 mini lots of EUR/USD. Your true leverage is about 90:1 ($40,000 / $440). You set your usual 30-pip stop loss and your trade loses. Your loss is $120 ($1/pip x 4 lots).

You've just lost 27% of your account ($120 loss/ $440 account). Your account balance is now $320.

You believe the tide will turn so you trade again. You buy 2 mini lots of EUR/USD. Your true leverage is about 63:1. You set your usual 30 pip stop loss and lose once again! Your loss is $60 ($1/pip x 2 lots).
You've just lost almost 19% of your account ($60 loss / $320 account). Your account balance is now $260.
You're getting frustrated. You try to think what you're doing wrong. You think your setting your stops too tight.

The next day you buy 3 mini lots of EUR/USD. Your true leverage is 115:1 ($30,000 / $260). You loosen your stop loss to 50 pips. The trade starts going against you and it looks like you're about to get stopped out yet again!

But what happens next is even worse! You get a margin call!
Since you opened 3 lots with a $260 account, your Used Margin was $150 so your Usable Margin was a measly $110. The trade went against you 37 pips and because you had 3 lots opened, you get a margin call. Your position has been liquidated at market price.

The only money you have left in your account is $150, the Used Margin that was returned to you after the margin call.

After four total trades, your trading account has gone from $500 to $150. A 70% loss! It won't be very long until you lose the rest.

Trade #Starting Account Balance# Lots of UsedStop Loss (pips)Trade ResultEnding Account Balance
4$260530Margin Call$150

A four trade losing streak is not uncommon. Experienced traders have similar or even longer streaks. The reason they're successful is because they use low leverage. Most cap their leverage at 5:1 but rarely go that high and stay around 3:1.

The other reason experienced traders succeed is because their accounts are properly capitalized!
While learning technical analysis, fundamental analysis, sentiment analysis, building a system, trading psychology are important, we believe the biggest factor on whether you succeed as a forex trader is making sure you capitalize your account sufficiently and trade that capital with smart leverage.

Your chances of becoming successful are greatly reduced below a minimum starting capital. It becomes impossible to mitigate the effects of leverage on too small an account.

Low leverage with proper capitalization allows you to realize losses that are very small which not only lets you sleep at night, but allows you to trade another day.

Example #2
Bill opens a $5,000 account trading $100,000 lots. He is trading with 20:1 leverage. The currency pairs that he normally trades moves anywhere from 70 to 200 pips on a daily basis. In order to protect himself, he uses tight 30 pip stops. If prices goes 30 pips against him, he will be stopped out for a loss of $300.00. Bill feels that 30 pips is reasonable but he underestimates how volatile the market is and finds himself being stopped out frequently.

After being stopped out four times, Bill has had enough. He decides to give himself a little more room, handle the swings, and increases his stop to 100 pips.

Bill's leverage is no longer 20:1. His account is down to $3,800 (because of his four losses at $300 each) and he's still trading one $100,000 lot. His leverage is now over 26:1.

He decides to tighten his stops to 50 pips. He opens another trade using two lots and two hours later his 50 pip stop loss is hit and he losses $1,000. He now has $2,800 in his account. His leverage is over 35:1.
He tries again with two lots. This time the market goes up 10 pips. He cashes out with a $200 profit. His account grows slightly to $3,000.

He opens another position with two lots. The market drops 50 points and he gets out. Now he has $2,000 left.

He thinks "What the hell" and opens another position. The market proceeds to drop another 100 pips and because he has $1,000 locked up as margin deposit, he only has $1,000 margin available, so he receives a margin call and his position is instantly liquidated.

He now has $1,000 left which is not even enough to open a new position.
He lost $4,000 or 80% of his account with a total of 8 trades and the market has only moved 280 pips. 280 pips! The market moves 280 pips pretty darn easy.

Are you starting to see why leverage is the top killer of forex traders?


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