How much leverage should I be using?Understanding how to trade forex requires detailed knowledge about economies, political situations, all the individual countries, global macroeconomics, the impact of volatility, it goes on and on. But the reality of the situation is this isn't what makes most new traders fail. What makes most traders fail isn't the lack of knowledge or understanding of what it is they're actually trading. It's the lack of knowledge and understanding on leverage.
As most of us would have heard, there is very obvious statistic out there that majority of retail traders fail. Now, most people will see this as a lack of competence and just purely not willing to put in the effort to be successful. But a lot of the time it is people not understanding the risk their undertaking and what it is they're actually doing with their money when they enter the market. It really highlights this when traders come to a firm like ours, and question leverage or they have so many questions about leverage that even though they've been trading for three to four years, they still don't fully understand the actual risks that are at hand when they are opening certain positions that they really can't afford to open.
Today I wanted to jump into leverage. Let's really dive into depth what it is, why we have it, how we can use it. Then, finally touch on what is the right amount of leverage for you as a trader. So you can be exponential in maximizing your profits, but also ensuring that you're not damaging yourself long term.
LEVERAGE RISK
Firstly, I think it's important for us to have a look into leverage. Leverage is the process in which an investor or trader borrows capital in order to invest or purchase something. Typically we borrow capital from a broker and we buy into positions with money that we didn't have in order to be able to gain more profit from those positions. Most traders are blindsided and constantly think the more money I have, the more profit I can make, which is true, but they fail to recognize that the more risk it carries.
Carrying higher leverage is an exponential increase in risk. Most brokers out there will probably offer you something like 50:1, 100:1 or even 500:1 leverage. This giving you a buying power of 50, 100 or even 500 times whatever the amount of money you have in your account. Which means a trader with just $100 in a brokerage account could open a position with $50,000 in the market. Now, while that may sound advertising, believe me, that's a trap and we're going to chat about that today.
HIGH LEVERAGE EXAMPLE
So let's dive into an example. Let's imagine we have a trader who has a $10,000 account. They decide to use 100:1 leverage, which now means with that $10,000 cash, they can trade up to $1,000,000 in the forex market. Let's assume that the trader opened a position with the full available capital which would relate to 10 lots, and they opened the position on a currency with the USD being the quote currency. That means that each PIP movement is equal to $100. So for a simple equation, if they were to enter a trade and that trade went against them by 50 pips, they would have lost 50% of their account because that 50 pips would have been equal to $5000. So in one wrong trade they lost 50% of their account.
So many people in this industry is so quick to look at what the realized gains could be, but they rather tend to ignore the actual risks that come with that. If you don't have sufficient evidence that your investment strategy is going to provide consistent and stable gains long term, do not look to trade with higher leverage, as you will be gambling and it is extremely risky.
LOW LEVERAGE EXAMPLE
Now let's use the same example, but in a lower leverage situation. The trader has $10,000 cash only this time he is trading on an account with 5:1 leverage, resulting in a buying power of $50,000. This means on a pair with the US dollar as the base currency that you can open a maximum size of 0.5 lots. Let's go ahead and take the exact same trade, only this time with a 0.5 lots, each pip is equal to $5. Should the investment or trade fall the same 50 pips this time the trader will only lose $250, which is a mere 2.5%. Same trade, different leverage, one lost 50% the other lost 2.5%.
It is a common trick out there that traders feel they require more leverage to really make money in the market. It's not true. Yes, it can help you get more profits from those smaller moves. Yes, it is really beneficial if you have a proven strategy. If you are still coming to grips with trading or you're fairly new and you haven't achieved consistency and profitability yet, focus on lower leverage. What it will actually do is make you focus on long term goals. Focus on the process this giving you more sustainability in the market and therefore more maturity.
CHOOSE THE RIGHT LEVERAGE
Choosing the right leverage is a very important step in Forex trading. You can be tapered in by fancy numbers and big brokers trying to get you in, Or, you can realistically dive into what it is you actually need and what's going to benefit you more in the future. There's no right answer to how much leverage you need each strategy in each individual require different things, but what I will do is share some tips and some knowledge on how to choose the right one that benefits you.
1. Always try and maintain the lowest leverage you possibly can for your strategy. If you manage to pull it right the way into where you can only just open the positions on the risk you have allowed yourself, and you can't open more than, lets say three positions, what you actually do is limit yourself to focus on only the good positions. You've prevented over trading from occurring and you can really focus on your risk management.
2. When you open positions or you talk about opening positions instead of going to people saying, "yes, I opened 0.35 lots." Use the actual dollar value when you open a 0.35 lot position. Instead, say "I opened a $35,000 position." Talking in that language that you have placed your bets with $100,000 or $1,000,000 will make you realize how much risk you're actually exposing yourself to and the capacity of what it is you are trading.
3. Limit your overall risk, at absolute Max, I risk 0.25%. This allows me to go into large drawdowns and it not be an issue. I can still manage it accordingly in it actually keeps me nice and calm and focused on the analysis rather than the running profit and loss.
The bottom line is selecting the right Forex leverage depends on the traders experienced risk tolerance and comfort when operating in the market. You want to ensure that it's not out there to harm you, but rather it's there to help. You do not want be trying to get really high leverage so you can make large profits, when you know realistically, there is no evidence to prove that you will make those high profits. Start small, gain consistency, gain exposure and gain experience, and then you can start looking to expand your equity and buying power.
Buyingpowereffect
Tutorial: "Safety Taping" Naked Positions to Bring in BPEExample 1: Safety Taping a Short Strangle
Pictured here is a BITO short strangle that I entered on 12/8 for a 1.59 credit on buying power of 24.16. (See Post Below).
At this point, I'm considering "safety taping" the naked short strangle off to bring in buying power effect. A "safety tape" setup can also be used to offer additional protection against an outsized move to either side and therefore limit loss.
In this particular case, I'm looking to shop for cheap longs in the expiry in which my short strangle is set up. I can also do this in shorter duration (which will not give me buying power relief, but will protect me from an outsized move), the same duration as the naked, or in longer duration.
Here, I can buy cheap wings that dramatically cut that 24.16 buying power effect. The 16/55 long strangle would cost .27 to put on (as of Friday's close) and would result in a 16/25/44/55 iron condor, the widest wing of which is 11-wide. This brings in buying power effect in from 24.16 by more than half, since the maximum risk of the safety-taped setup is that of an 11-wide minus the net credit received.
Naturally, I'm paying a debit to do this, which reduces my net credit received for the setup from 1.59 to 1.59 - .27 = 1.32, but it also dramatically improves my potential ROC as a function of buying power effect from the original 6.6% at max to 13.6% at max.
Example 2: Safety Taping a Short Put
For "wheelers" (i.e., short put, acquire, cover), safety taping off short puts can also conserve buying power, particularly in a cash secured environment like an IRA.
Example:
BITO January 21st 23 Short Put
.61 Credit
Buying Power Effect: 22.39 (Cash Secured)
ROC as a Function of BPE: 2.72%
vs.
BITO January 21st 16/23 Short Put Vertical
.53 Credit
Buying Power Effect: 6.47
ROC as a Function of BPE: 8.19%
Setting Alarms For Fun and ProfitOne of the most attractive things about being a trader is that once you become proficient with your trading system you don't have to spend all day in front of your computer like an extra in the Walking Dead. There's a lot more to life than trading. The goal is that once we have developed that skill, we can “trade to live” and not “live to trade.”
I like to teach that trading is like fishing - Your job is to go into the water, cast a few lines, and wait for the fish to come and snag a hook. The keyword there is wait . Once you set your lines, you don't have to babysit them: go do something else. (We trade to live, after all!)
Likewise, with trading, once you have developed a certain level of skill in "setting your lines", you should only need to spend about 30-60 minutes in front of your computer "working". Then you simply need to wait until the trade, that is price, gets snagged onto your hook. In the meantime, go do whatever it is in life that you enjoy doing.
How do fishermen then know when a fish has taken the bait? Some fishermen attach a small bell on the end of their pole, a “fishing buddy”, and as the fish jerks the line the bell alerts the fisherman that “he’s got a live one!”
How is is that Alarms can instantly become your "fishing buddy?" Let us count the ways:
First: Management of Buying Power
Let's say you have a $10,000 trading account. You wake up, do your morning routine, head to your home office (or the kitchen table) and “go fishing” in the Futures markets. You find three great opportunities for Soybeans, Oil, and Copper. The margin requirements for each of them (per contract) is $4,500, $5,800, and $7,300, respectively.
Futures trading requires that you have a certain amount of capital in your account per trade setup, known as the margin, or buying power, at the time you setup your trade. This "margin" is set aside in your account and can't be used, even if the trade hasn't been triggered or entered. If you wanted to setup all three of those trades before you headed to work you would need $17,600 in your account. But you only have $10,000. What do you do?
In the past, when I ran into this situation, I would have to guess (or hope) I would choose the correct trade to place before I left for work, and send just that one trade to my broker. Inevitably, I would choose the one losing trade, or the one that didn't get hit , and it ended up that one or more of the other trades turned out to be winners - the trades I did not take - all because I couldn't put on all three at the same time. Aaargh!!! Every day I felt like the trading gods were against me!
Here's where alarms can become your best friend.
Let's say at any given moment if you received an alarm, you would be able to respond to that alarm within an hour. You could setup an alert line 1/24th the daily ATR away from your entry price. For example, at the time I am writing this, the Daily ATR for Crude Oil is 1.7708 - the average distance or range that Oil trades in a day. Divide that by 24 and on average, oil moves about .0738 per hour.
If you are looking to go long oil at $73, you would draw a horizontal line at 73.0738, and set an alert on the line, giving you about an hour to check that the trade is still valid. When price activates your alert, you can log into your trading platform, verify that you still want to take the trade, right-click the long-short tool (which you had setup beforehand) and send the trade to your broker, whereby then and only then will the $5,800 be allocated from your Buying Power.
It is unlikely that all three trades will hit at the same time so this gives you the "buffer time" needed to efficiently manage the available capital in your account to take as many trades as possible.
Using alerts in this manner can help you minimize the number of missed opportunities you might experience because of the limited amount of buying power you may have.
Second: Trade Opportunity Alerts
In the futures market, I have what I call my "31 Flavors" - the 31 Futures contracts that I actively trade. On any given morning I might find 5 assets where I’m looking for a long opportunity, another 5 assets that I’m looking for a short, and the rest aren’t in any trend or environment where I’m looking to trade.
Many indicators let you set an alarm when a certain condition occurs. For instance, I can set an alarm on the ten high-probability assets I have flagged to let me know “Hey, Captain: a Sabre Long opportunity just formed on the S&P;”, or “Hey Captain, a short opportunity with the pattern you are looking for just popped up on Crude Oil.”
Likewise, if you are following a Moving Average strategy, you can setup an alarm saying “Hey, Trader: XYZ just crossed the 89 Moving Average” or "ABC just crossed the 40 day Moving Average.
At the time of this writing TradingView will let you setup up to 400 of these alerts. (P.S. - If you need more than 400 alerts, you're probably overtrading... just sayin') :-)
When the alert is triggered you can just take a few minutes out of your day outside of your normal trading hours to check in and see if that mid-day opportunity is worth setting up. After a couple minutes, you can get back to what it was you were doing.
The myth of the day trader who is glued to his or her computer all day in fear of missing an opportunity is just that - a myth, because alerts free you up to do what is important. Remember, we are trading to live - we aren't living to trade.
Finally: Trade Management
Let's say you are a swing trader. Trades you enter may take anywhere from 3 to 30 days to hit their target. Say, however, you have a hard and fast rule to take 3R profit from all of your trades because you would rather take 3R any day rather than see price go to 5R, or 7R, just to have it come on back and stop you out for a loss due to emotions or lack of paying attention, because, yes, you trade to live - you're not tethered to your computer or smartphone all day. You've got better things to do. (At least I hope you do!)
You can setup an alarm to let you know that a trade you have running achieves 3R of profit, whereby you can then move your stop, then check in on it each morning and/or evening to see how you may want to lock in more profit or call it a day and cash in on your winning trade.
Conclusion:
In short: Use alarms to make your trading more efficient, more effective, and ultimately, more profitable.
Are there any other ways that you use alarms to maximize your trading game? Let us know in the comments... I'm sure we are all, myself included, dramatically under-utilize this very powerful trading tool.
Trade well, everybody!
OPTIONS TIP: BUYING POWER EFFECT REDUCTION/BUDGETING WITH LONGSWhen playing with a small, cash secured account, buying power effect can limit one's ability to trade since even something as basic as the 30-delta 27 short put in ROKU in the June cycle pictured here can tie up quite a bit of buying power.
The June 15th 27 short put brings in a nice 1.27/contract in credit, but comes with a cash secured price tag of the strike price (27) minus the credit received (1.27) or 25.73 ($2573)/contract in a cash secured environment. Depending on the size of your account, that simple sub-$50 underlying could be a "big" trade. For example, if you're playing with a $10k account, that one play would represent your hanging out more than 25% of total account value on one play in a single name; by most standards, that's wayyy too big a play relative to account size.
However, by taking one simple step, you can reduce the buying power effect of going naked and give up very little premium in the process: by buying the cheap June 15th 19 long, which will cost you .15 ($15) at the mid price.
Naturally, you give up $15 in credit over the naked, but you reduce the buying power effect of the setup dramatically: to $687, allowing you to use the buying power you saved to get into other plays ... .