Risk and leverage are two scary terms but they go hand in hand when it comes to trading, especially in highly leveraged markets like FX and CFD’s.
To explain how things work, let’s take a look at some examples.
First of all, we are going to assume that the trader is trading EUR/USD and a standard contract size which is 100,000.
Most brokers offer 100:1 leverage, some go to 500:1 or even 1000:1. This just translates to the amount of money you need in your account to take the position. This means that with a 100:1 leverage, you need only $1,000 to take a position on 100,000 and with 1000:1 you need only $100 to take the same position.
The only statement that could be an absolute truth for the above is that the higher the leverage, the lower the capital required to take the position.
The next and the tricky part is the risk management.
When it comes to risk management, each trader has his own philosophy. Some work with a percentage of risk on overall account per trade, so they may risk say 3% of their capital on each trade. Some would risk 3% of the funds required to enter the position. Some determine it based on the distance from the entry. This article is not aimed at giving any advice on what is the best strategy, but rather showing how risk management is affected by the capital in the account.
Let’s consider for the purpose of this exercise that someone has $1,200 in their trading account. He trades with a broker that offers 100:1 leverage so he can take a trade of 100,000 EUR/USD. His margin used will be $1,000 and he will have free equity of $200. If his strategy is to risk 3% of his account, which would be $36 that equates to 3.6 pips, his margin would be reached in less than a few seconds. After 7 consecutive losing trades, he will no longer be in a position to take the contract. There is also the fact that once he takes that one trade, he cannot take any further positions even if they present themselves. The choices he has is to either take smaller contracts, increase his leverage or increase the equity on his account.
If he decides to increase his leverage, it still does not detract from the fact that he has a very low margin for error and a very high risk of loss as he is only allowing the EUR/USD to move 3.6 pips against him. Some brokers may not even allow a trader to place such a trade with a stop loss of 3.6 pips as it would be either too close or even within their spread.
The solution left for this trader is to reduce his contract size down to say a mini lot which is 10,000 exposure on the market, so 100:1 leverage would require $100 of margin and each pip would be worth $1. In this case the same 3% rule being applied would mean that he can allow for $36 which equates to 36 pips. The probability of the market moving 36 pips is less than the market moving 3.6 pips. The other option is to increase his investment in the account from $1,200 to $12,000 and still maintain the standard lot size of 100,000.
A major part of risk management is to reduce the probability of loss as this would increase the profitability. There is enough research, based on the trading style of a trader as to how much volatility one could expect in the market they trade for the time frame they trade and a suggestion is that if your stop loss is outside of that band, then risk of loss is lower. Then, if you still keep 3% of the capital being risked on a trade, it would determine how much capital is required or what the trade size should be.
The biggest tip I can offer after having observed and worked with traders, including hedge fund managers and master traders, is the following:
“Give the market room to breathe. This means that you should allow your strategy to succeed and hence place your stop according to the expected volatility of the market and adjust your trade size according to the capital you have. “
What this equates to, let’s say that you want to still risk no more than 3% of your account on each trade, but market volatility dictates that for you to give yourself the best chance of success, your stop should be at least 60 pips from entry. In this case it means that you should have at least $2,000 capital in your account to trade mini lots or $20,000 to trade a standard 100,000 lot size.
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