How to Overcome Trading Mistakes - Part 2

04/09/2014 9:00 am EST

Focus: FOREX

James Stanley

Trading Instructor, DailyFX Education

Leverage amounts can have a massive impact on success of traders, and in this second of a three-part series, James Stanley of DailyFX.com talks about the next most common mistake traders make.

In our last article, we investigated the top trading mistake. As we showed, human emotion is often the culprit behind this primary mistake, and this can be off-set through planning, discipline, and trade management.

Unfortunately, profitable trading isn’t as easy as just setting a positive risk-reward ratio and hoping for the best. There are other mistakes and pitfalls that traders can fall prey to, and in this article we’re going to look at the next most common issue.

After all, if we keep gambling everything in our account on just one trade (even if we are looking for two or three times that amount on the profit side with a strong risk-reward ratio), we’re likely to face disaster. Sure, we may win one, two, or three times, seeing our account grow massively…but eventually, we will be wrong. And when we are wrong, we lose everything in our account. Game over: And it doesn’t matter how many times were right leading up to the inevitable carnage of our accounts.

The topic for today’s discussion is leverage.

Leverage in the FX Market
One of the greatest benefits of the FX market is also one of the most difficult things to grasp: Flexibility.

In stocks, leverage is generally limited to two times the trader’s equity (a 2:1 leverage ratio); and if “pattern-day-trader” status has been obtained, the trader may be able to access four times their account’s equity (4:1 leverage ratio). So, if a trader has $25,000 in their account, they can take on positions of up to $50,000 (2:1), or $100,000 if they are classified as a “pattern-day-trader,” (4:1 leverage).

In the FX market, much more leverage is available; and this leverage is like an “amplifier” for traders. If a trader is leveraged 10:1, and the asset they are trading moves 1%, then the trader sees a difference of 10%. This can be a gain, or it can be a loss; as the old saying goes: Leverage is a double-edged sword.

But what traders need to realize is that the amount of leverage taken on has enormous impacts on their psychology, their emotions, and their trade management.

Traders need to leverage enough to capitalize on the trade when they are right, but not so much that any one or two trades might cause irreparable damage.

Leverage is very much like speed or velocity when driving an automobile. Sure, higher speeds (larger amounts of leverage) might be able to get us where we want to faster. But the risk of ruin (an accident or a large, outsized loss) increases with higher speeds (or more leverage).

Larger amounts of leverage can make traders more vulnerable to their own emotions; as highly-leveraged positions amount to larger swings in equity, further exposing traders to the number one mistake that forex traders make.

The Impact of Leverage
This was another point of investigation in the DailyFX Traits of Successful Traders series. We initially wanted to see how traders performed based on the amount of equity in their accounts. What we found was shocking.

Traders with less than $1,000 in their account were far less profitable than traders with $5,000-$9,999. A common rebuttal when one first sees this data is that traders with $5,000-$9,999 are professional traders and far more experienced than traders with less than $1,000 in their account.

And while experience levels may be a very relevant account for this difference, it doesn’t explain the entirety of the deviation, as there is a massive deviation in the profitability of these groups of traders.

Traders with $5,000-$9,999 were profitable 75% more often than traders with less than $1,000

chart
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Slightly more than one out of five traders was profitable in the sub $1,000 group, while well over 1/3rd were profitable in the $5,000-$9,999 group.

NEXT PAGE: What’s the Right Amount of Leverage?

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And the fear of the data being skewed by professional or significantly-more experienced traders is rather moot considering most professional traders keep considerably more than $10,000 in their trading accounts.

There is a massive deviation between these two groups of traders so, naturally, the next question was why?

We found that traders with smaller balances took on far more leverage than the other groups in the observation. The table below shows the effective leverage of each group (in red). Notice how much more leverage is being taken on by traders with less than $1,000.

Traders with smaller accounts took on far more leverage, and were much less profitable

chart
Click to Enlarge

Traders with less than $1,000 in their account were taking on an average of 26 times leverage. This means that for every $100 in their account, they were trading a position of $2600. This is like learning to drive while going 150mph on the Autobahn. Can you make it out alive? Sure. But you also run a much higher risk of catastrophe.

But notice that the traders in our other two groups took on considerably less leverage, with six and five times leverage respectively. These traders also saw far greater profitability, because they weren’t taking on so much risk (leverage) with each position that they were trading.

What’s the “Right” Amount of Leverage?
Unfortunately, only you can answer this question.

As human beings we all have different risk tolerances and characteristics. Some traders prefer to trade with extremely low amounts of leverage in an effort to “be safe,” while other traders would merely fall asleep if carrying a trade at two or three times their account equity.

What we can say is that the “best-of-the-best” in trading often keep their leverage amounts below 10x their portfolio value. In many cases, it’s below 5x (Less than 5k in positions for every $1,000 in account equity).

But one thing is for certain, there aren’t many great traders that consistently trade with exorbitant levels of leverage, because they almost all get wiped out at some point because of the very thing we pointed out in this article.

Eventually, every strategy faces losses and every trader hits a drawdown. If leverage is too high during these periods, that trader runs a massive risk of “wiping out,” their account equity.

My advice for traders looking to get more comfortable with leverage is to start slowly. Initially traders should start without any leverage at all… so if you have $10,000 in your account—only entertain positions of $10,000 or less. A 10k position with a $10,000 account is 1:1, or no leverage.

If you have $1,000 or less in your account that means that you can look to the smallest trade size available, which is usually 1k.

Now, I realize this may be unexciting for traders. I’ve been there myself, where it almost feels like it can be a waste of time to trade with small lot sizes and lower leverage amounts. But that’s ok…this isn’t supposed to be exciting. It’s supposed to be a “more safe” way of becoming a better trader without taking on exorbitant levels of leverage like we saw in the research.

After you’ve become comfortable trading with no leverage, slowly work your way up. The first change should be to 2x leverage (so for every $10,000 in your account, you can investigate 20k in positions).

After you gain comfort there, you can look to increase your leverage amount again.

If, at any point, you feel discomfort when leaving a trade, especially if you feel discomfort despite the fact that you have a stop and limit attached as we had investigated in the previous article, you are taking on too much leverage.

When discussing leverage, it’s always advisable for traders to err on the side of caution, because opportunities in markets are infinite: Capital most definitely is not.

In our next article, we’ll continue the series by delving into the concept of strategy employment.

By James Stanley, Trading Instructor, DailyFX.com

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