Leverage in Forex Trading

The leverage available in forex trading is one of main attractions of this market for many traders. Leveraged trading, or trading on margin, simply means that you are not required to put up the full value of the position. Margin means is the amount of money you can borrow for each dollar you have in your account. For instance, in the case of a 100:1 margin, for each dollar you have in your account, the trading company with whom you open your trading account will lend you 99 dollars to sell or buy $100 dollars.

There are reasons for the higher leverage that is offered in the forex market. The volatility of the major currencies is less than 1% on a daily basis. This is much lower than an active stock, which can easily have a 5-10% move in a single day. With higher leverage, one can capture higher returns on a smaller market movement. Furthermore, leverage allows traders to increase their buying power and use less capital to trade. But increasing leverage increases risk. So beginners beware of the leverage trap.

Now, depending on the trading company you open your trading account with, you need to trade at least a given number of dollars (or units of another base currency). This is called a lot. The standard lot is $100K, but there are smaller lots (10,000K and 1K) that are now available. There are even trading copmanies where you can choose any size you want from $1 and up. If you have a limited budget, the latter entities are your friends for reasons that will become apparent latter, and you should pay attention to it.

Now suppose that you want to buy $10K of USD/JPY. In the case of 100:1 margin, you will need $100 to open the trade. If the USD/JPY appreciates by 1%, you will make $100 profit. But if the USD/JPY depreciates, you will lose money. If for instance the USD/JPY loses 0.5%, then you will lose $50.If you had only $100 dollar in your account at the start, then if you win in your first trade your account will increase to $200, but if you lose it will shrink to $50.

If your trading account accepts only lots of size of at least $10K, and if your first trade was a 0.05% loser, you cannot place another trade since you will not have sufficient funds. You will need an additional $50 to meet the margin requirements (you need a total of $100, and since you only have $50 you will need another $50).Suppose that you have a 50% to have a winner trade, and 50% chance to have a loser trade. The winner makes 1%, the loser loses 0.05%. This is in general a winning scenario, but as we will see the new trader can end up losing because of a lack of understanding of margin and other things.

As noted above when the first trade was a loser, we could not continue if we start with $100 only. This means that we need more money to start with to make sure that you do not (or make the chance of such scenario very small) run into the problem of not having enough money to continue trading. We want to make sure that the risk of ruin is small, and the initial budget plays a role in this.

The chance of having 20 successive losing trades in the example of this article is roughly one out of a million. Suppose that we take this risk, meaning we will assume that we will not be the unlucky person to experience a streak of more than 20 successive losses. At loss number 20, we would have lost $1000. Since we must be able to make trade number 21, we will need to start with at least $1100.

The point you should take from this is that your initial budget is critical in being a winner in trading Forex. For a given margin, a given percentage loss on a trade, the probability of a losing trade, and the minimum lot you can trade, you can compute the initial budget you will need.

From a practical point of view, you should allow enough number of trades in order for the law of the average to take place. In the order of 25 trades should be able to reveal an acceptable estimate of the average return on each trade.

If we assume to take the risk of N trade without a winning trade, then we will need as initial budget:S/M+ N*L*S,where S is the lot size, M the margin, L the loss fraction.

If we divide the margin by the initial budget, we obtain roughly M/(N*L*S).

In the above example this is equal to 100/(20*0.005*10000) which is 10. Therefore, we really do not need 100 as a margin but rather only 10 in this example.Since we do not need more than 10 as a margin if we want to trade properly and be a winner in the example above, then any higher value might hurt a new trader who does not understand and/or appreciate the effect of margin on trading success.

Now if you are given a margin value, you also want to make sure that you only use a fraction F of the account balance in any one trade such that the amount you would lose in any one trade is less than your budget divided by N.This means that M*F*L must be less than 1/N. Or than the product of M*F is less than or equal to 1/(N*L). In the example above this leads to M*F is less than or equal to 10 (=1/(20*0.005)).In conclusion this article shows you how to select you initial budget, and how to select the right fraction to trade for a given margin M.

The formulas to use are:

1. Initial budget: S/M+ N*L*S

2. Size of each trade: S

Contributions to this article were made by: Chabillion