One of the biggest benefits of the FX market is also one of the primary causes of failure for new traders, and that is the available leverage in the market. One of its greatest features- flexibility – can very easily become one of its biggest hurdles. The goal of this article is to share with traders how to become more comfortable with this pivotal aspect of the FX Market.
Before we delve deeper into the concept of trade sizes, it’s important to point out that many of the best traders in the world keep leverage at a moderate quotient of 10:1 or less. This would be like trading position sizes of $ 100,000 with a balance of $ 10,000 in the account (100k trade size divided by $ 10,000 equity = (100k/$ 10,000 = 10-to-1 leverage (often expressed in ratio form as 10:1)). In the FX market, leverage of 50:1 is available to most traders, with much more available in many jurisdictions.
While this can be beneficial in those instances in which the trader finds themselves on the right side of the move, the results can be catastrophic when traders find themselves on the opposite end of the trade.
The very act of over-leveraging can also change our outlook, reactions, and decision-making processes. This is often why the best of the best traders in the world keep their leverage at more moderate levels of under 10:1.
Using higher degrees of leverage introduces multiple points of risk in the portfolio that can greatly change the way that traders manage positions, enter trades, or even analyze markets.
Why is Leverage so Important?
Do you remember what it’s like when you learned to drive? For those in New York City, or other cities with access to public transportation, this analogy may not ring as true so we’ll explain below.
When learning to drive, students are instructed to first start out at low speeds. This is a very logical introduction to driving, as the slower speeds allow greater reaction times – limiting risk by eliminating the dangers that can come with higher speeds.
As drivers get more comfortable, they slowly but gradually increase their speeds.
Eventually, they are driving on the highway with the rest of the market.
Leverage is like velocity; high rates of speed and/or leverage can be dangerous
And some take this a step further, and go far above the posted speed limits; exposing themselves to an entirely new set of risk factors that can greatly increase the probability of an accident.
Professional race car drivers routinely reach over 200 MPH (equivelent to 320 km/h), but that doesn’t mean that every experienced driver should. And to new drivers that have very little experience operating a motor vehicle, the potential downsides can be catastrophic.
Leverage is velocity
When new traders are learning to speculate, much like new drivers learning the ways of the road, less risk is often best.
Just like new drivers needing to control their speeds while they are learning the ways of the road, traders should learn to speculate at lower levels of leverage while learning the ways of the market.
Not only can lower leverage make mistakes LESS expensive, but it can also make it easier for new traders to learn the ever-present range of emotions that goes hand in hand with the art of speculation.
How ‘low’ is low – and how can traders learn to use leverage effectively?
Unfortunately, there isn’t a hard rule for how much leverage is ‘best’ for new traders. At DailyFX, we teach traders to first get comfortable with the operation of the market on the demo account with no financial risk exposed. Once comfortable risking hard capital, traders should look to trade with very little, or no leverage at all.
So, for our trader with a $ 10,000 equity line, this would mean trading one mini lot (10k size position), or perhaps two mini lots at a maximum (10k trade size/ $ 10k equity = 2:1 leverage).
Once comfortable trading with small amounts of leverage, traders can look to increase leverage at their discretion.
In our Traits of Successful Traders series, we found that traders using moderate levels of leverage in the observed period saw far better trading results. The below picture, taken directly from the article ‘How Much Capital Should I Trade Forex With,’ traders using 5:1 leverage were profitable a full 76% more often than traders using more exorbitant levels of leverage (26:1 in the observed research).
Less is More; Traders using more moderate leverage saw far better results
Taken directly from ‘How Much Capital Should I Trade Forex With.’
While using static leverage amounts can be helpful, such as taking on 50k in positions with equity of $ 10,000 (10k X 5 = 50k), there is perhaps a better way for traders to calculate trade sizes.
After all, keeping risk at 5:1 doesn’t ensure traders against catastrophe. If a trade is left un-managed, 5:1 can create a margin call just like 50:1 can create a margin call (albeit at a slower pace since less velocity is being used).
A better way of going about this would be to limit total exposure on any one ‘idea.’ This can be done by allocating a percentage of the account to the trade. This way, risk can be managed across multiple trades in a uniform manner so that total exposure, at any one time – is contained.
So, for instance – as opposed to opening up a trade at 5:1 leverage, instead choosing to risk 1% on the idea, and then determining the trade size based on the desired stop amount.
This way, if the trade doesn’t work out – the trader has 99% of their account remaining.
The formula for doing this is as below. All the trader needs to know to perform this calculation is their account equity, desired risk percentage, and desired stop distance. The formula is in blue, while an example is in red. The example is using the following details: $ 9,185 Account Equity, with 1% to be risked with a 75 pip stop on this trade in USDJPY.
— Written by James Stanley
James is available over Twitter @JStanleyFX