Understanding leverage in forexPlease note: In earlier posts I use the term micro-lots for the basic 0.01 (1 cent) lot size I use on InterbankFX, as that is how they are named by them. This relates to a position size of $100.
However, a normal micro-lot, as determined by most brokers, is 0.10 (10 cents), and relates to a position size of $1000. Therefore, to avoid confusion, from now on I’ll refer to my trading unit of 0.01 as a nano-lot.
I’ve already mentioned that for the purposes of learning a new system, or understanding Money Management, a broker that offers 400:1 Account Leverage is the one to use. I would prefer you demo first, but this may require you set a higher initial practice account size than my example will show. Nevertheless, the math is the same. As a matter of interest I use InterbankFX, as mentioned before, but you use whichever broker you think might suit, as long as they offer 0.01 (or lower) as their basic lot size. Oanda does offer these lower lot sizes, and many traders around here use them, but I have no experience with them so cannot comment. Search in the Broker Discussion thread and ask the traders who use them for more information.
Now I often hear the comment that high leverage like this is a BAD thing, and newcomers should stay away as it’s the quickest way to lose money.
This is true if you don’t understand the difference between Account Leverage (also known as Broker Leverage) and True Leverage. I’ll try and explain the difference as I go along. By the way, I’ve run this section past a very experienced trader to verify the points I’m making, so you can relax as you read this.
You may, or may not, be aware that the Standard Trade size in the real trading world is $100,000.00 (one hundred thousand dollars). Not many of us have access to sums like that, so the folk who give us the opportunity to trade allow us to leverage whatever money we do have spare. Therefore, instead of having to stump up $100K we can trade ‘on leverage’ and only put up a percentage of that figure.
Typically a leveraged trade only requires us to put up $1000 for every $100,000 of currency we wanted to buy or sell. This equals Account Leverage of 100:1. Now if you only have an Account size of $5000, and you put $1000 of it on a trade, you’re dealing with True Leverage of 20:1. This would be fine if a couple of things always happened.
You never had a bad trade. EVER!
You didn’t have to pay the spread. EVER!
Now the problem with trading, and the fact that you’re reading this tells me you’ve already discovered this, is that you will have bad trades. In addition, you will have to pay the spread.
Using True Leverage as high as 20:1 is a recipe for disaster for guys like us, whether it’s thousands, hundreds, or even tens of dollars, we are using, depending on the size of our account. This is covered in more depth in the Money Management part of the Information For Beginners thread (Post #18 onwards) in the Forex Beginner Q&A section.
Let me do this exercise on an account size we can all relate to - $300.00. I’ll do this in nano-lots as well; as that’s the way I trade. If your demo shows $3000 as the minimum size of your new account, keep your lot size to 0.01. I’ll repeat the exercise to show how to arrive at the same risk per trade using a larger account size.
For the sake of simplicity (for me) I’ll stick with GBP/USD as my pair to trade, the dollar value is always equal to 1 (i.e. 100 pips profit = $1), whereas the crosses can vary, typically .8 (i.e. 100 pips profit = $0.80 cents).
One simple thing that escaped me in the early days was this; if I traded GBP/USD I was essentially either selling dollars (long GBP) or buying dollars (short GBP). Stupid, I know, but it’s often simple things that make the difference. My trading account is dollar denominated so it was important for me to understand this, and I didn’t. The same rule applies in relation to any pair you’re trading; it’s just the actual currencies that are different. I can remember saying ‘Ooh look the yen’s going down’ when in fact it was the dollar diving south. How dumb can you be? All you need to remember when looking at a chart is that, with any currency pair in a rising chart, the first named currency is strengthening in value against the second named currency. The reverse is true in a falling market, i.e. the first named currency is weakening in value against the second named currency.
Exercise 1 ($300 Account):
Right, I’ll break this down as far as I can. Our $300 trading account allows us to trade using nano-lots. 1 nano-lot allows you to buy or sell a USD position size of $100.
The next thing we have to establish is our risk profile. Even when you’re trading in pennies, you need to think Money Management, and now is a good time to get into good habits. All the serious traders I’ve ever listened to say 2% of your account is a good figure to base your maximum risk on. It’s even better to go with 1%, so we’ll start there.
1% of $300 is $3 (300 cents), so that’s as much as we want to risk on each trade. We know we can expect losing trades, so now we have to work out where we think we should place our stops in order to take us out of this trade if things go wrong. Maybe the system you’ve been working with has a fixed stop loss. Let’s assume it’s 50 pips above/below entry. Therefore, we now have 300 cents (our financial risk on this trade) divided by 50 (our technical stop on this trade), this equals 6 (0.06) nano-lots.
We’re risking $3, but you’re effectively buying 600 dollars (if you’re short GBP) or selling 600 dollars (if you’re long GBP). Your account, when you start, is $300 so your True Leverage is only 2:1
$600 position size traded on a $300 account equals True Leverage of 2:1
Exercise 2 ($3000 Account):
Our $3000 trading account allows us to trade using nano-lots. 1 nano-lot allows you to buy or sell a USD position size of $100.
We’ll stay with 1% as our risk profile.
1% of $3000 is $30 (3000 cents), and our stop is 50 pips. Therefore, now we have 3000 cents (our financial risk on this trade) divided by 50 (our technical stop on this trade), this equals 60 (0.60) nano-lots.
We’re risking $30, but you’re effectively buying $6000 (if you’re short GBP) or selling $6000 (if you’re long GBP). Your account, when you start, is $3000 so your True Leverage is only 2:1
$6000 position size traded on a $3000 account equals True Leverage of 2:1
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Forex Account size and leverageOne question that occurred to me the other day is why would brokers give us unlimited time to demo trade their platforms, and why they set the minimums at say $3000? They must incur costs supplying data feeds, updates etc. Maybe I’m being cynical but here’s my take on it.
Most newcomers don’t understand the difference between Account Leverage and True Leverage, and the brokers rely on the greed motive to sucker people into false expectations. If someone has opened a demo account, and has been trading risky amounts per trade, there’s a 50/50 chance they just got lucky during a big trending period. Their instinct will be that there is easy money to be made here, and they’ll fund a live account with at least the same amount as their demo. After all, $3000 isn’t a great deal of money for some people. Moreover, who has read the Risk Warnings attached to all the brokers’ websites and actually decided not to try trading because of them?
If many of the posts on the forum are typical, a fair proportion of those new traders will be dead in the water within months. Many will tuck their tails between their legs and never be seen again. Some will stick another lump of money into their accounts and try again, and all this time the brokers are gaining their spread income, to say nothing of all the other little tricks that they are (allegedly) accused of.
I’m not sure I’ve ever seen a broker advise a new trader to only trade single lots whilst learning how to trade. They may mention controlling risk, but it’s not until you find somewhere like Forex Factory that this will be spelt out in ways that you can understand.
So, back to my original thought. I’ve no idea how many new traders enter the FX market every week, but if the stats are anywhere near accurate, it means that 90%, or more, of these new traders donate substantial amounts of money to brokers’ bottom lines.
This is why playing them at their own game, taking advantage of the huge leverage they offer, can, if you learn patience, bring you out on the right side.
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Forex Leverage - the matmematicsAnother reason for sticking with nano lots (0.01) is the flexibility it gives you in controlling your risk, and compounding your account over time. I’ll cover this in more depth in the Money Management section, but I need to justify my argument here.
Let’s assume you’ve decided to put up $500 to fund your trading account. You’ve been demo trading for a few months, and been reasonably happy with your progress. You’ve listened to all the advice about trading with scared money, and you’re happy to lose this amount, if things don’t work out. It won’t affect you, or your family, and you’re treating it as training funds. If it disappears, you’ll stick some more in while you’re learning. You don’t want to lose it if you can avoid it, but you KNOW that demo trading isn’t real trading, so you are keen to see if you can handle the emotional issues that will come trading with proper money.
Remember, your account is $500 and you’ve decided on 1% as your risk. For all intents and purposes, a mini account is out of the reckoning. With only $500 to play with you may need to risk between 5% - 10% of your account on any single trade simply to place 1 lot, depending on the size of your stop.
Therefore, this leaves us with Micro and Nano Accounts. The next set of examples will use a 65-pip stop loss, and, I hope, will show the extra flexibility of starting with nano-lots. Please note that I’m still dealing with GBPUSD as my pair.
(A) Nano Account (0.01 = $100 position size)
Account Size: $500.00
Risk Profile: 1%
Amount Risked: $5 (per trade)
Stop Size: 65 pips
Pip Value: 0.01 (1 cent)
Pip Value risked: 65 * 0.01 = 65 cents
Position Size: $5/0.65 = 7.69 nano lots (0.07 rounded down)
(B) Micro Account (0.10 = $1000 position size)
Account Size: $500.00
Risk Profile: 1%
Amount Risked: $5 (per trade)
Stop Size: 50 pips
Pip Value: 0.10 (10 cents)
Pip Value risked: 50 * 0.10 = $5
Position Size: $5/$5 = 1 micro lots
(C) Micro Account (0.10 = $1000 position size)
Account Size: $500.00
Risk Profile: 1.5%
Amount Risked: $7.5 (per trade)
Stop Size: 65 pips
Pip Value: 0.10 (10 cents)
Pip Value risked: 65 * 0.10 = $6.5
Position Size: $7.5/$6.5 = 1.15 micro lots (1 rounded down)
As you can see it will be necessary to either reduce your Stop (example B), or increase your risk (example C), in order to place your trade.
These smaller lot sizes give you enormous advantages in trade size flexibility. For example, if I had $25k in my nano account (I can hope, can’t I?), and I still worked to 1% risk (assuming a 65-pip stop loss), I could trade 384 nano contracts. In a mini account, with the same $25k, I could only trade the equivalent of 300 (3 mini lots @ 1.00). It’s only 84 contracts, but think how much this would be worth over a series of trades, assuming they’re all winners, of course?
Regarding the question of granularity, Diallist (while vetting my earlier posts), raised another point, as follows:
As for granularity, the smaller the better, but the importance of this decreases with an increase in account balance. A micro lot is preferred over a mini lot at all times, but the advantage of increased profits resulting from the finer granularity diminishes as one’s account approaches about $35,000. The larger one’s account, the less important the granularity provided by micro lots becomes. For really huge accounts, even the granularity of a mini lot becomes unimportant.
As your trades run their normal course, and your account balance fluctuates, this flexibility ensures that you can easily keep your trade size equal to your risk profile without having to round your positions up or down to suit the larger minimum lot size offered with a mini account.
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Leverage and Money ManagementThere is one more important element in trading a nano account, again relating to Money Management, and that is the flexibility of stop loss positioning. One reason that many of us run up large series of losing trades, in the early days, is the fear of loss itself.
Because we don’t know any better, we set our stops for illogical reasons, one of which is the repeated warning: Cut your losing trades short, let your winning trades run!
How can we judge, as newbies, which is which? We’ve all had the experience of trades going bad, getting stopped out, and then heading off into vast (potentially) profitable runs with us on the sidelines cursing and swearing. In many cases, even without any great technical knowledge, an extra 10 – 20 pips breathing space on our stops would have kept us in to reap our reward.
With a nano account, you have this extra flexibility; you can try new methods of setting stops (trendlines, Support & Resistance zones etc) without increasing your risk profile. All you need to do is re-calculate your position size to suit the larger stop.
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Why Trade daily timeframes?Understanding the Retail FX Market ( Pit Traders and us )
As very few of us have any experience of how pit traders (also known as a locals) work, we can have no idea of the ways that price can be manipulated to a professional’s advantage.
Consider this, however. All around the world there are 1000s of traders, of all different skill levels, trying to make money on the movements of various currency pairs. You need to understand where you are in the great scheme of things, and adapt your way of trading to suit.
I can best describe this mass of traders in simple terms; one of the world’s toughest contact sports – Rugby. For those of you not familiar with this sport, it’s similar to American (Gridiron) Football, but without all the padding. A Rugby team will have 15 players on the field at any one time, and a limited number of substitutes. In Gridiron Football you’ll have a bunch of guys sitting on the bench tooled up and ready purely for either offensive, or defensive plays. In Rugby every player has to have a combination of offensive and defensive skills. The rules governing Rugby are more complex, and to the layman can seem impenetrable.
So how can we relate this to FX trading? Well I look at it this way; you have a team of mixed skills; some, called the backs, are speedy and can move fast if an opening presents itself. What they can do is easy to see, if there’s a gap they’ll go for it. If they’re running into trouble they’ll off-load as soon as they can. These are your typical intraday scalpers, and shorter-term traders. They need to be fleet of foot, and have a highly developed sense of self-preservation. Very occasionally, they’ll get the chance to go for a long run and make big yards for a try (touchdown).
In front of them are our forwards; heavyweight hitters who dictate field position, setting up opportunities for the backs to exploit. Without their expertise the team has nowhere to go. The real stuff that goes on amongst the forwards, at times, is beyond even the referee’s ability to apply the rules. When the two sets of forwards get into a scrum, only those in the front-row really know what’s happening. To be honest, even their own backs have little knowledge, or desire, to get involved. All they’re concerned about is will they get a chance to run with the ball?
Pit traders are like the forwards; we don’t understand what they’re up to, and it’s unlikely we’ll ever get the chance. Even if we did, we would be trampled underfoot in no time at all.
So how can we apply this to our trading? If you remember that during normal trading times, when liquidity is low, your local is looking to gain his profit on very small moves in the market. Our forwards are like this, always trying to gain a few yards here, a few yards there. Imagine a situation where a local, or group of locals, are short the market, but the market gives every indication of rising. These guys are looking to get out with any sort of profit, to break-even or, at worst, a small loss. At times of low liquidity it may be possible for them to bid the price enough to shake the confidence of the weaker traders, causing them to cover themselves by selling their long positions. Other weak traders, seeing the market starting to head down, jump in to climb on the sell-off bandwagon.
Now that the locals have moved price enough, they get out of their short positions with whatever they’re happy with and start snapping up (buying) all the sell orders that are sitting around. Price can now do what it wanted to do and head up. This is why it’s hard for newcomers to make money trading the short time-frames. You’re up against people that understand the rules better than you, and they can trade position sizes big enough to affect the market, and so confound your systems.
A classic example of this is the Overbought/Oversold type of indicator. We all make the mistake, as newbies, of poor analysis of the indicators we choose for our trading; falling into the trap of only seeing the points where a trade would have won. It’s human nature to look for the upside, and skip over those same scenarios where we would have had a losing trade. We want to win, so we blank out the negatives.
All I would ask is that you go back over your charts and really look at them. See how long an oversold, or overbought, situation can last. Look at your losing trades and see how you could have been more selective before entering. Just because the indicator is crossing some arbitrary boundary doesn’t mean that the world and his mother has suddenly changed their outlook on where price is heading overall. Balance what you see with what is happening in the next higher time frames. Missing a few pips at the start of a move is immaterial, if it keeps you out of a losing trade.
Just remember, you don’t know what the forwards are doing, and neither does the rest of the on-line trading community, the small-time parts of it, anyway. Let them do their stuff, wait till the move looks set, pick up the ball and run for all you're worth.
But off-load your trade as soon as trouble appears!!!
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