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

Common Beginner Mistakes - Entry

The chart on the left shows short (sell) trades on the EUR/USD that was placed yesterday evening by a beginner (my brother). Three trades were opened within a five-minute time frame towards the end of a fall in prices.

Of course, when the trades were placed, he did not realize that there was an end to the fall in prices. His rationale was simple - prior to opening the positions, he noticed that the prices were falling markedly. He did not want to miss an opportunity to get in on the action, so he quickly placed the three trades.

That was common beginner mistake number one; ie, rushing to place the orders without first studying the chart because you are afraid of missing a big move. It is never wise to place trades when a big move (in this case, a fall in prices) is already in motion. Instead, it is better to wait and see what happens. If he had waited, he would have seen that the prices were starting to make a turn upwards!

The second mistake made in this trade was that he sold right when the prices were on (or near) the lower blue line (the 24 bollinger bands). Typically, buyers are waiting to buy at the lower blue line. If someone wanted to sell, the best place to have done that would be at the gray line (the one in between the two blue lines). But by the time the price went to the gray line, it would have become obvious that the price had already reversed directions, and was now heading up!

The take-home lesson in this example would be to not enter a position when a big move is already in play. Be patient and wait for the next opportunity.

Currency Trading

I began trading currencies about seven to eight years ago. I was looking for a way to earn fast money from home without putting in much effort. I opened my first currency trading with FX Solutions, and promptly lost all the money I had in the account. Thankfully, I had only begun with the minimum requirement for opening the account, which was a $100.

I did not know anything at the time about leverages, margins, moving averages, nor even how to read the trendline and charts. Subsequent attempts also met with failure - I think I must have cleaned out my account about 3 times before I started to make consistent money!

Since then, I have devoted time to observe and learn the currency markets. And today I am happy to say I can make money doing currency trading on a consistent basis.

Still, currency trading is risky because the markets are volatile, and the up and down trends can change very quickly. Even an experienced trader can make mistakes, so if you don't know what you are doing, chances are you will end up losing, and the getting disillusioned about the whole trading business.

Recently, I opened a sub-account for my younger (teenage) brother with the intention of introducing him to the basics on currency trading. Since then, I have observed him making several mistakes, especially in questions of when to open positions, when to close, what is the right size of units to place, confusion about what the different moving averages mean, the MACDs say etc.

So I thought to create this blog to discuss the principles of successful currency trading, as I teach my younger brother, in the hopes it benefits another beginner currency trader out there. I am particularly hopeful that women readers benefit from my blogs because I don't find too many women with similar interests in currency trading.

I hope to discuss the common mistakes beginners make, show my trades, my wins and my losses, and analyze the reasons why it is so.

Happy reading.