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How the Best FX Traders Use Leverage
10/28/2015 9:00 am EST
Study shows that most forex traders are largely undercapitalized and highly overleveraged, while those who win consistently are much more conservative with their leverage. Here's how they do it, according to the staff at DailyFX.com.
Research shows that the amount of capital in your trading account can affect your profitability. Traders with at least $5,000 in capital tend to utilize more conservative amounts of leverage. Traders should look to use an effective leverage of ten-to-one or less.
In looking at the trading records of tens of thousands of forex traders, as well as talking with even more traders daily via live Webinars, Twitter, and e-mail, it appears that traders enter the forex market with a desire to cap their potential for losses on their risk-based capital. Therefore, many newer traders choose to start trading forex with a small capital base.
What we have found through the analysis of thousands of trading accounts is that traders with larger account balances tend to be profitable on a higher percentage of trades. We feel this is a result of the effective leverage used in the trading account.
Since many smaller traders are inexperienced in trading forex, they tend to expose their account to significantly higher levels of effective leverage. As a result, this increase in leverage can magnify losses in their trading account.
Emotionally spent, traders then either give up on forex or choose to compound the issue by continuing to trade in relatively high amounts of effective leverage. This becomes a vicious cycle that damages the enthusiasm which attracted the trader to forex.
No matter how good or bad your strategy is, your decision (or non-decision, as the case may be) about effective leverage has direct and powerful effects on the outcomes of your trading. Last year, we published some tests showing the results over time of the same strategy with different leverage.
In the above graphic, we have modified two elements of the chart in figure 1. First, we renamed each column to represent the highest dollar value that qualified for the given column. For example, the $0-$999 equity range is now being represented as the $999 group. The $1,000-$4,999 equity range is now being represented as the $4,999 group, and likewise, the $5,000-$9,999 range is now being represented as the $9,999 group.
The second change made was that we calculated the average trade size of each group and divided it into the maximum possible account balance for that group. In essence, this provided us a conservative and understated effective leverage amount. (A larger balance reduces the effective leverage so the red line on the chart is the lowest and most conservative calculation of the chart.)
For example, the average trade size for the $999 group was 26k. If we take the average trade size and divide it by the account equity, the result is the effective leverage used by that group, on average.
As the effective leverage dropped significantly from the $999 group to the $4,999 group (red line), the resulting proportion of profitable accounts increased dramatically by 12 basis points (blue bars). Then, as further capital is added to the accounts as they move into the $9,999 category, the effective leverage continued to incrementally drop, pushing the profitability ratio even higher to 37%.
NEXT PAGE: How Much Effective Leverage Should I Use?|pagebreak|
How Much Effective Leverage Should I Use?
We recommend trading with effective leverage of ten-to-one or less. We don't know when the market conditions will change, thus causing our strategy to take on losses. Therefore, keep the effective leverage at conservative levels while using a stop loss on all trades. Here is a simple calculation to help you determine a target trade size based on your account equity.
- Account Equity x Effective Leverage Target = Maximum Trade Size (All Combined Positions)
The above illustration shows a trader's account size and the maximum trade size based on ten-to-one leverage. That means if you have $10,000 in your account, then never have more than $100,000 in open trades at any one time.
The precise amount of leverage used is decided entirely by each individual trader. You may decide that you are more comfortable using an even lower effective leverage such as five-to-one or three-to-one.
Most professional traders enter into trading opportunities focused on how much capital they stand to lose, rather than how much capital they are looking to gain. Nobody knows the future movement of prices, so professional traders are confident in their trading approach, but conservative in their use of effective leverage.
Adjusting Effective Leverage to Suit Your Risk Tolerance
Our research indicates that accounts with the smallest capital base (the group labeled $999) have an average trade size of 26k for each trade. Their effective leverage is at least 26 times, which is significantly higher than the ten times leverage discussed earlier. If these traders want to trade at no more than a ten-to-one effective leverage, they would need to make at least one of the adjustments noted below:
- Increase their trading account equity by depositing more funds to an amount that reduces their effective leverage to less than ten to one. An average trader, who is averaging 26k trade sizes, would need at least $2,600 in their account to trade 26k on a ten-to-one effective leverage.
- Decrease their trade size to a level that reduces their effective leverage to less than ten to one. (Use the figure 3 calculations and chart above.)
In the chart above, notice how the trade size remains relatively stable as the account equity increases from the $999 group to the $4,999 group. In essence, this indicates that traders are looking for, on average, at least $2.60 per pip (if they average 26k trade size, that is approximately $2.60 per pip in most currency pairs).
There could be many reasons why traders average at least 26k for each trade, or $2.60 per pip. Perhaps they want a large enough trade size to make their time spent trading worthwhile.
In other words, traders may be seeking a price-per-pip value, and $2.60 is the minimum threshold, on average. If these traders were to use no more than ten-to-one effective leverage, they would need at least $2,600 in their account to support $2.60 per pip.
Another possibility is that many newer traders simply don't understand the power of leverage and how one large losing trade can wipe out several winning trades in a row. Using a conservative amount of leverage will help slow down the rate of capital losses when a trader goes through a losing streak.
Regardless of the reasons, our goal is to use conservative amounts of leverage. If you know how much risk capital you have available, then use the chart and calculations from Figure 3 to determine an appropriate trade size for your account.
If you have a target "per-pip" value, then use the calculations in figure 5 to determine the minimum amount of account capital needed to support your trade size.
Increasing your capital base does not mean you will become more profitable. It means that you can stay in a trade longer if it goes against you. On average, traders who use a combination of sufficient capital (at least $5,000) and conservative use of effective leverage (ten-to-one or less) tend to be more profitable.
By the Staff at DailyFX.com
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