Understanding Leverage Pt II
Leverage is not even a double-edged sword, it’s a guillotine - and your head is on the block – PART 2
Dr Forex says - Let me explain to you once and for all
why and how leverage destructs trading accounts.
I am very pleased with the reaction I received on my “Leverage Part 1” newsletter. I get the impression that it helped to clear up a number of issues for forex traders “out there”.
I hope that this newsletter will help you to change your position from being “out there” to “in here”.
“Out there” is a maze, mostly the blind leading the blind, and all spell-bound by the illusions created by the marketing wizards of forex. Forex forums are popular – they have become sites where the uninformed can meet with the unsure and concoct theories that are unsustainable. Would-be traders who don’t know what they are looking for tend to frequent these forums and as Yogi Berra, the famous baseball player said "You've got to be very careful if you don't know where you're going, because you might not get there."
“In here”, with me, you will know where you are going and together we will reach the destination of consistent and profitable trading.
To re-cap
Last time I said that with leverage we must clearly distinguish between what’s available (100:1, 200:1, 400:1, 500:1) and what you can choose to use. I showed you how the marketing wizards trick people into trading with very high leverage, convincing them that it is a good thing. These people are often unaware of the devastating effect of leverage on their account. It’s like speeding on a mountain pass but thinking you are on the flats. It can only end in one way … disaster.
We concluded that:
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What is usually referred to as leverage is actually the margin required expressed as a ratio if you use all the borrowing power the broker will allow you to.
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Real leverage is determined by dividing your capital into the value of your positions.
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Real leverage can differ from trade to trade and increases with multiple simultaneous trades (open positions).
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Margin required has no influence on your risk if you trade properly with modest leverage within your means and margin is not to be used as a risk calculating principle.
I also want to re-cap on the most basic issue regarding leverage, that is, its proper calculation.
Leverage is about borrowing money. To calculate leverage you must first know how much you have and then you must divide that into how much you are going to trade with (the size of the lot you are going to buy, or in effect, borrow).
Let’s say you have €20,000 and you do a trade (buy EURUSD of 100,000). Your leverage is 100,000/20,000 = 5:1. For every €1.00 you actually have you trade with €5.00.
Now I specifically used euro as an example as I want to make sure you understand the difference between “Trader’s leverage” and “Professor’s leverage”. I did refer to this in the Part 1, but only in passing and because this is important I want to make very sure you understand what I mean.
I guess many readers of BWILC (the book) skipped Part 3 – “All that Jazz”, or flipped quickly through it and missed the part where I explain leverage. They may also have missed the very important little paragraph on base currencies and currency quoting conventions. For real money dealers in banking dealing rooms these things are of paramount importance and it is second nature to them, but for some reason retail forex speculators see it as of minor importance and thus they make crucial mistakes in calculating their risk.
You see, if you look at a leveraged transaction in the futures market or the stock market the calculation is really simply - as in the example above. If you live in India and you do a leveraged transaction on the Indian stock exchange you have rupees and your borrow rupees and you trade some listed stock on the stock exchange. It is a very straightforward calculation: divide what you have into the value of your deal. But matters are not so simple in the forex market.
The first minor complication is making sure you know what you have. In other words, in what currency is your account? Let’s assume it is US dollar. (I think many more US traders should diversify their trading account to other currencies as a way of mitigating the risk of having all their eggs in one basket.)
The problem with leverage calculations in foreign exchange is that you have to divide apples into apples. Consequently you must express the base currency of the currency pair you trade in the currency of your account.
So we are back to basics. What the heck is a base currency? It is not the currency of your account. The base currency is the currency named first in the currency quotation. When we say EURUSD, euro is the base currency. When we say USDJPY, US dollar is the base currency.
When we say the price of EURUSD is 1.2755/8, then we mean for each euro you will have to pay 1.2758 US dollars if you buy euro and if you sell euro you will receive 1.2755 US dollars. Let’s say that with our $10,000 US dollar denominated trading account we buy one “standard lot” of (€100,000) EURUSD. The value of the transaction in US dollar terms is $127, 580. We have $10,000 and therefore our leverage is 127,580 / 10,000 = 12.75:1. For each one dollar we trade $12.75 - we have leveraged or geared our account 12.75 times. (There is no difference between “leverage” and “gearing”.)
But it became commonplace in the retail forex world to simply express such a transaction as having leverage of 10:1. Doing this ignores the fact that we are dealing with both apples and pears and just divide the 10K into 100K. It is an interesting question why this has become the normal practice, and I would like to spend some time explaining why I think it has.
Some history
In December 2003 the US regulator, the CFCT, which in terms of the Commodity Futures Modernization Act (2000) started to oversee OTC (over the counter) forex, issued new margin requirement rules. It seems to me that until then the marketing wizards advertised 100:1 or 200:1 leverage (or 1% margin requirement) without understanding that whichever is the base currency of a specific transaction has an important impact on the margin they require. They simply didn’t care. All accounts were in US dollar and they simply charged 1% of the number 100,000 currency units as if it was always US dollars. At the time the most traded currency pair - EURUSD - was valued less than one dollar per euro, and so this didn’t have an impact because the margin was actually more than 1% of the contract value. For example, while EURUSD traded at 0.9250 the contract was worth $92,500 and $1,000 was more than 1% of that ($925).
This changed when the euro increased substantially in value to more than $1.00 per euro, and suddenly the margin they charged was less than 1%. The CFTC also issued rules during 2003 that the margin requirements of retail OTC (OTC vs exchange traded) forex brokers must be brought in line with those of the exchange traded forex futures. This caused an uproar because the margins needed to be up to 4% - 8% and the marketing wizards objected that they would lose money to unregulated companies.
Their objections worked (as we all know by now) because margin requirements are still from as little as 0.25% based on transaction sizes, with the most common at around 1%. What the regulator did achieve is to force the correct (accurate) calculation of margin as a percentage of the base currency contract amount.
Understanding the exact amount that you trade should be pretty important, one would think. One would also think that retail traders that pay good money for trading advice, or training, from an e-book to a classroom course or home study course, will receive correct guidance in this regard. Unfortunately this is rarely the case.
How too high leverage kills potentially promising trading careers
Leverage amplifies the volatility in the market in the leveraged trading account by the factor of the leverage.
I am going to explain this problem with a story of two friends, Frank Marks and Buck Sterling.
Frank is a teacher in history and doing his PhD on ancient civilizations and Buck is a computer programmer. For his yearly vacation Frank decides to visit Stonehenge in the UK and he consults Buck who has recently started exploration in currency trading, assisted by an e-book “Forex Trading for Idiots”.
They went to a free seminar but Frank decided it was not for him. Buck however forked out the $1,500 for a weekend course, with free prices, free graphs, free this, free that, and a system to leverage his $3,000 to make $1,500 a day trading the British pound around the “London open”.
Buck initially struggled but recently he got the hang of it and made no less than $70,000 demo dollars. Slightly in awe Frank enquired of Buck how he was doing it and what the essence of the system was. Bucks reply? “Leverage buddy, leverage”. (Let me also add that Buck had $50,000 demo money.)
So Frank, mindful of his pending trip to the UK asks Buck to let him know when the best moment would be to exchange his money for Pounds Sterling and Buck obliges, showing him on 5 minute, 15 minute and 60 minute charts when the moment has come to buy GBP - the stochastix screams ”buy” and the fantastix promises wealth. At the top of the hour Frank rushes over to the Bureaux de Exchange and pays 1.88 US dollar for each of his 5,000 GBP. Altogether he pays $9,400. Buck, who has now written a programme on his Easy Money forex software, has just made 15,000 pounds worth of demo money overnight. Frank is becoming envious.
Buck explains to Frank that the Alligator has hoisted the white flag upside down with a Doji dangling from the Hangman’s noose yesterday; the Resistance is throwing away their guns while the Support is building a new base closer to the action on the daily charts; and your lucky star is in the right quadrant because the Paralytic Tsar made a handbrake turn on the dot. Translated, says Buck to Frank, it means that if Frank buys another 5,000 GBP while he is at it he is going to make a tidy profit because, “‘the GBP trend is up and the trend is your friend”, says Buck paging through Forex Trading for Idiots.
Frank rushes off to the Bureaux de Exchange and buys another 5,000 GBP. Buck was correct; today Frank paid 1.89 dollars per pound Sterling. Total expense: $18,850 for GBP 10,000. By the time Frank is on the plane, Buck is launching his trading career with real money, funding his commission free, two pip spread on majors, 200:1 leveraged trading account at Money-for-Jam Capital Partners with a $20,000.00 deposit.
The next few weeks Frank has a wonderful time in the UK and decides a week before his return to visit the Arlington racecourse and play the horses. The GBP is now trading at 1.95. Of course Frank thinks that Buck is rolling in money – the trend is one’s friend. Frank’s luck holds and he wins GBP 10,000 with the Pick Six after Long Shot wins the 6th race by a wet nose.
At home a few days later he exchanges it (his 10,000 GBP) for USD at the airport for a rate of 1.92. Frank receives $19,200. He has made $350 after being on vacation. Not bad. Buck, however, should be a millionaire by now!
First day back on the job Frank finds Buck deeply engrossed in a computer program. His two trading screens are blank.
“You were right”, says Frank with admiration. “The trend is your friend.” He places a souvenir from Arlington on Mark’s desk. “I had a great holiday and afterwards I was in the black, thanks to you. You’re a genius. What’s the pound trading at now?”
“No idea”, says Buck his head down.
A little taken aback Frank asks about the Paralytic Tsar, whether the Resistance is still building bases, and if the Hangman has been busy. “No idea”, says Buck, “I am not interested.” He looks wretched. The penny drops for Frank.
“How much did you lose Buckey?”
“Twenty K”. Shocked Frank presses Buck for an answer.
“Leverage buddy, leverage”.
Later the two talk in more detail and the sad story unfolds. Says Buck:
“The problem was that initially I was a bit too conservative. I made a few good trades with 50:1 leverage. In other words I made $100.00 per pip. By the time the GBP hit 1.9500, I was up to $40,000. So I decided to increase the stakes a bit and I leveraged the 40K 80:1, in other words I would make $320.00 per pip. I had to place the stops a bit closer, because that is how Idiot Money Management works. So I placed the Idiot stops 15 pips away, initially. What happens? I get taken out 3 times in a row, same day, $14,400 down the tube. What happens then? The market turns around and heads off in my direction just after having stopped me out. In fact, my third stop was taken out on a downward spike and 20 minutes latter two of my trades would have been in the money.”
“Well the next day the trend was back and I bought another 80:1 now with 30K, so $240.00 per pip. I realized this GBP is a bit volatile – and so I kept the stop, this time at 30 pips. Well call me the stop-out king. I was taken out by only 5 pips. That was $7200 down the drain. I realized it made a double top at 1.95 and got the signal that the trend has changed - 15 minute Parabolic SAR was crystal clear. I sold big time ….. $200 per pip.
So what happened next? I am not too sure, at some stage I was 50 points up and then all hell broke loose and well, I had my stop well out of the way. That was $6,000 gone and from there it was pretty much all over. I had to use tight stops because I didn’t have much left in my account and the same thing kept happening over and over. I started realising that volatility with real money is a bit different from volatility with demo money. I can’t explain it, it just seems bigger. My stops seemed like magnets drawing the market. Ping! Stopped out, market reverses and goes in my direction. Well, two days later I had 3K left. Money-for-Jam Capital Partners has the rest.
Let me tell you something Frank, leverage is not a double-edged sword - it’s a bloody guillotine and my head was on the block”.
Buck had to deal with the variance in his account created by market volatility and amplified by leverage. It would seem that Frank had a punt, and Buck lost money in an adverse market. In fact they were both gambling, the only difference being that Frank knew his win on the horses was a matter of luck. It is part of our psychology that when we do well we ascribe it to our talent and when we do poorly we ascribe it to bad luck. Often it is just randomness, nothing more and nothing less.
The cost of leverage
This story, with different shades but the same central theme, is repeated every day as aspiring forex traders burn out accounts.
In addition to the fact that high leverage forces you to place close stops - the bread-and-butter revenue for the forex broker - and dramatically increases the chances of you becoming a victim of the very short-term randomness of the forex market, it is also costs you a whack.
Many traders think there is no cost in trading because the spread is not seen separate from either the pips they lose or the pips they make. This is wrong because a transaction consists of two parts. The cost, and then the profit or loss. The cost is the amount debited to your account equity if you closed a trade you have opened immediately, without a change in market price.
Let’s say you get a GBPUSD quote 1.8650/55. You buy at 55 and if you sell immediately you would sell at 50. Your cost to deal is 5 pips. You broker sold to you at 55 and bought from you at 50. We can say the real market is already 5 pips against your position. You can’t claim the spread, unless you make a winning trade – if the market moves in your direction you reclaim the spread. But if you make a losing trade there is a 5 pip cost in addition to what you have lost due to an adverse price movement. The higher you are leveraged the more the spread costs you, bleeding money from your account
Let me give you a practical example. Highly leveraged retail forex speculators would jump at the chance of using a trading system that is wrong 35% of the time but because it cuts losses and runs profits, they are confident they would come out ahead. They would be wrong.
If you are un-leveraged, the only way in which you can lose all your money is if the currency you hold loses all its value.
From a cost point of view Frank Marks, when he bought his GBP probably paid a 15 pip spread at the Bureaux de Exchange. For him to lose all his money something would have had to happen to GBP to make it lose all its value – a meteor from the heavens obliterates the UK. Unlikely. And so, the GBP value Frank holds is relatively stable. But the moment you add leverage it amplifies in your account, creating instability, as the story of Frank and Buck illustrated.
But what I really want to get to is this: If you take an active highly leveraged trader who does, say, 40 trades in a month leveraged at 20:1, the real cost of his trading before profit or losses due to price fluctuation starts playing a role. The maths looks like this: 40 trades X 5 pips x 20 (mini) lots = $4,000. If he is using the trading system that is wrong 35% of the time (he is getting stopped out because of short stops) the cost that he can’t recoup is $1,400 or 14% of his capital. That is a direct cost to your trading business, and it is this cost that I am attacking – it is a highly questionable “overhead” if you consider that trading is a business.
If a trader using this trading system breaks even he is a very good trader. But in the long run he will eventually lose because the leverage, besides whatever else it does, is draining his account.
If you understand randomness you will know that those 35% of losing trades can come at any time. They can be the first 14 trades of the month. The effect of the highly leveraged losses on a trader’s equity, only once, with a really bad run, can be devastating to his account. In order to maintain his “system” he has to drop his transaction size, particularly after a bad run. Therefore it is going to take him a lot longer to make up the losses. In the process, even though his transaction size is smaller, his leverage is still the same (and too high) because his margin is dwindling.
If you really want to work out your return then you should work out your return, not expressed as a percentage of your margin but as a percentage of the total value and cost of your transactions. >/p>
Leverage amplifies everything in your account – at the same time not much has changed in the markets.
Another consequence of leverage is that it amplifies the variance in your account equity. And this (variance) has nothing to do with sustained profitable trading.
In the short term, days, weeks, months, (some will even say a few years) if you look at the result of your trading, there is a good probability that all you are seeing is random variance cloaked by the pretence of an intelligent trading system. There simply isn’t enough data to establish that what you see is the result of any edge or skill that you have.
It would be completely insane for Frank, after his visit to Arlington, to start a career as a bookmaker. But in the same way it was just a little bit less naïve for Buck to think that he had cracked it based on a few weeks of positive variance in his demo account.
If you know anything about probabilities you will know that the chances are very high that a series of coin tosses will end 50 / 50, either heads or tails. But did you know that if you take a series of 100 coin tosses the range of 50 / 50 will mainly be between 38 / 62 with very few lying outside these parameters.
Unfortunately it seems to be part of human nature (behavioural psychology has proved this) that we tend to see patterns or series where they don’t exist. And we usually do this based on insufficient data. Novice traders who so dearly want to do well are especially prone to reading into a short profit series that they have some edge and that they are on the brink of a long-term successful career in trading. Once they open their live accounts, probability rears up and bites them.
I want to make this very practical.
Let’s say you use 20:1 leverage to do all your demo trades and you hit a good run of luck and end positive, making 20% that month. Remove the leverage and thus the amplified variance in your account equity and your return may have been 2% - and that was during a good short run. What is going to happen if you have a longer period of say four months with three “bad” ones? You are nowhere. If you maintain the high leverage you will have losses during the bad runs that probably exceed the profits during the good runs.
By deciding at the end of a good high leverage stint you are now ready for real trading is exactly the type of thing that Money-for-Jam Capital Partners would want you to do, because they know they are going to get money for jam – from you.
What I am talking about is how variance in your account forces upon you a changed and negative mindset. You cannot concentrate on the market, which is what a trader should always be doing. Instead you are obsessed with the chaos in your account. What is the price out there, what are the factors you should be aware of? You don’t know. Your energies are being utilised in completely the wrong place. In short, you have lost the sort of perspective you need in order to trade successfully.
You find yourself in a situation where you can’t even handle the natural swings and retracements that occour in a trending market.
Variance of this magnitude due to leverage not only robs your account of money; it robs you of the ability to trade sensibly. Simply put, to be able to buy low and sell high you need to have an idea of what’s low and what’s high in the market. But it is exactly this perspective that you lose, paralysed with fear of further losses in your account as opposed to “further losses” in the currency market.
Can you make money with low-leveraged trading?
Good and well some will say, with your low-leveraged system you can’t lose too much, but can you actually make money? Is it worth your while? I believe you can, and in addition to the track record in BWILC where I show how I made 74% in two months on a trading account with low leverage, I can show you how others are doing it. To make money your forex trading strategy must be based on a genuine edge to beat the basic 50 / 50 odds of any trade.
I have developed a strategy that provides an edge. I call it my 4X1 strategy: one currency, one direction, one lot and one percent. This is my E=mc2 and just like Einstein’s formula turned a few things that were taken for granted upside down, this formula turns upside down the sort of orthodoxy and accepted wisdom peddled in books such as Forex Trading for Idiots.
Here is a fascinating true story from one of my clients. When he started out with my mentoring programme his answer to the question - Assuming that you have struggled until now, what would you ascribe this to? – was:
Most of my struggles have been believing what I have read on trading systems. Biggest problem has been placing stops too close to random price movements in order to limit my % of risk on the overall account. You are the first to expose this folly to me. However, I’m now concerned on just how to make any “real” money with so little gearing.
That was in January 2006. In March 2006 he funded a live trading account of $5,000 and by end of August 2006 his account was well up. After 5 months of trading, using the above formula and appropriate low leverage he was looking at an annualized return of 278%. His actual return was 129% - in anyone’s book that should count as “real” money.
Oh, and his trade accuracy is 90% (ie 10% losing trades), the typical losing trade is larger than the typical profitable trade and the largest single profit was 4% of initial trading capital, which shows that there is a real edge, not a one-night stand on a single big trade that convinces you of your own new-found “brilliance”.
Have a look at the details here: 129% in first five months
(Scroll down and click on the “Free” button next to the “PREMIUM” button. Then scroll down about half-way down until you find “Non-premium user. Please enter…” with a code. Enter the code and it will take you to the page.)
Next time
The latest fad in forex trading: “News Trading” – How to start a random shoot-out on Main Street and kill a score of innocent bystanders in the process.
Kind regards
Dirk D. du Toit
Friday, July 6, 2007
Understanding Leverage Part 1
Understanding Leverage Pt I
Leverage is not even a double-edged sword, it’s a guillotine - and your head is on the block – PART 1
Dr Forex says - Let me explain to you
once and for all that leverage is not what
brokers allow you to use, it is what you decide to use.
At long last I am at the point where my Bird Watching in Lion Country Newsletter is ready for publication. If you haven’t received one before, don’t start searching amongst your spam filter emails. This is the first newsletter.
Choice of topic is a difficult matter but “leverage” was always high on the priority list for the first issue. Recently I once again realized clearly how misunderstood this vital concept was to all aspects of forex. In my mind there is no doubt that most of the trouble that forex traders have starts with leverage.
I will dedicate this first newsletter then to this concept –
leverage and its destructive power in the retail forex trading world.
A few facts
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Personally I have not seen one wiped out trading account that wasn’t leveraged too high.
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I have also no record of any sustained profitable trading account based on high leveraged, short-stop trading.
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I ask my mentoring clients early on what they believe are the reasons for previous losses. Most answers include something to do with leverage, not understanding it at all, or only partially, or underestimating it once they have understood it.
Leverage then, is …?
I get many questions, like the one below:
I'm reading your book and I'm really enjoying it. Can you provide me with the information where I can get 1:1 leverage with the company you mention on page 108 of your book? I'm using a demo with only $1500 in the account with 200:1 leverage and I'm a bit worried about this even on 1 mini contract with one currency.
Or:
I contacted the broker you suggested where I could trade with less than $10,000 with low leverage, but they only offer 50:1 leverage and not 3:1 like you suggest.
It is very clear that leverage is misunderstood and this misunderstanding is a root cause of forex trading losses and the futile attempts to overcome these losses without addressing the root cause.
Regulatory warnings that leverage is a double-edged sword that can work for or against you go completely unheeded, just as the warning “past performance is no indication of future performance” is flatly ignored.
Leverage is largely misunderstood because the marketing wizards of forex (your friendly forex broker) have done a slight-of-hand trick that shifted the focus from the very important fact of how much the trader levers his trading capital to how much the forex marketing wizard is prepared to lend the trader.
Everything you read about leverage has to do with the maximum leverage you can achieve and very little about the prudent application of leverage in a forex trading system. In other words, the broker is telling you how much he will allow you to leverage, if you want to, not how much you should leverage, if you know better.
Warren Buffet said – “Risk is not knowing what you are doing”.
People speak about 100:1 leverage – “I trade with 100:1”, without knowing what it means. I will show below how you are your greatest enemy by being ignorant about this vital concept. I hope many of you will get a very important “AHA” experience from the newsletter.
Definition of leverage
This is a general definition:
The mechanical power or advantage gained through using a lever.
A definition found at www.investorwords.com says leverage is:
The degree to which an investor or business is utilizing borrowed money.
Closer to forex trading: www.thefreedictionary.com
The use of credit or borrowed funds to improve one's speculative capacity and increase the rate of return from an investment, as in buying securities on margin.
Enter the concept of “margin”. Let’s make sure we understand what margin is:
Definition of margin
The amount of collateral a customer deposits with a broker when borrowing from the broker to buy securities.
This is exactly what you do if you open a forex trading account. You deposit collateral in order to be able to borrow currencies to trade currencies. Actually you don’t have to borrow, but you can if you want to.
The moment that borrowing comes into play it is common knowledge that the amount that the lender will be prepared to lend has certain limitations. Obviously you can’t lend indefinite amounts.
The thing that stumps most traders is the fact that the marketing wizards use the terms “leverage” and “margin” very loosely and interchangeably. This causes a lot of confusion. I believe this is done deliberately because it is in the forex broker’s interest that traders do not see high leverage as a destructive problem but as an opportunity.
Let’s make sure we understand first “leverage” and then “margin”.
To understand leverage properly for trading purposes, let’s use a well-known concept. You want to buy a house, you don’t have the capital available, but you have a salary and can pay instalments on a regular basis, so you go to the bank and borrow money to pay for the house. So you are leveraging your income / salary.
There are limitations based on, amongst others, your income which means the amount you can borrow based on your income will be limited. There is a maximum you can borrow. Obvious, yes, but a very important concept for the lender – the maximum he should lend you in order to get the maximum return on his capital without overexposing himself to risk of default on your side.
(Just a thought from the sideline. If trading forex is mostly with borrowed funds why don’t the brokers ask interest? Think about that …. )
Remember this: The lender is focused on maximums whereas the borrower should be concerned with minimums - borrowing as little as he can but still getting bang for his buck.
Now we turn to your trading account: you want to increase your speculative capacity by leveraging your investment, therefore you borrow money to trade with from your broker.
Before your broker will lend you money you have to put down margin, which you wish to lever. Your broker, being a prudent businessman has calculated his risk beforehand and is quick to tell you what the maximum is he will allow you to borrow from him. In forex it is typically one hundred times your capital but it can also be two hundred times your capital or even four hundred times your capital. This is one part of the equation:
“Dear valued customer, you will be able to leverage your money 100:1, (200:1, 400;1). We hope we can have a long and mutually beneficial relationship.”
The other side of the equation is how much of this available borrowing you want to utilize in your speculative endeavours.
How much leverage you apply is your own decision
and not something the broker can force on to you.
Here is proof:
We are going to start with a stock market example.
You open a trading account with a stockbroker, with say, $10,000. You can buy stocks to the value of $10,000. Let’s say you did. Did you leverage your funds?
No. You didn’t borrow a cent from the broker. You have $10,000 and the value of your stocks when you purchased them was $10,000 (ignore costs for the moment).
How do you calculate your leverage?
You divide your capital into the value of your transaction and express it as a ratio of “value of transaction” : “capital”.
In the above example you divide $10,000 / $10,000 = 1:1
Well, your friendly online stockbroker one day sends you a message that they now allow margined trading and you can borrow funds to purchase stock up to the value of your current stocks. For simplicity sake we say the value of your stocks is still $10,000. In other words you can now buy another $10,000 worth of stocks while your capital input remains $10,000.
You do this after you just received a hot tip and now you have a transaction value of 2 X $10,000 = $20,000 divided by your capital of $10,000 = leverage of 2:1. Or you can choose not to, it depends on you.
Vital for the broker: Maximum leverage allowed
The maximum leverage you can apply (as opposed to how much you want to apply) is your broker’s decision:
The important thing you have to note in the above example is that you have utilized all the leverage you were allowed by the broker. This is vital. The broker takes a huge risk to lend you money and therefore they have certain rules which you must adhere to. There is a limit to what you can borrow from them. In the above example the limit is leverage of 2:1 or seen from another viewpoint margin of 50%. You must have at least half the value of your total transaction available in margin (in other words collateral in case you aren’t as hot a trader as you thought).
Margin is usually expressed as a percentage, while leverage is expressed as a ratio.
The marketing wizards of forex realized that the fact that they can offer very high leverage will be to their advantage to lure online investors from the traditional markets. Furthermore, many online investors’ portfolios were devastated by the 2000 crash and losses of up to 90% of formerly lucrative stock portfolios became commonplace – much of this leveraged through stock option schemes.
As a result they started to tout from the rooftops that leverage of 100:1, 200:1, and with the introduction of mini accounts, even 400:1 and 500:1 was available.
Terms like “trade with 100:1” leverage became the order of the day.
An unsuspecting and clueless online trading public swallowed this hook, line and sinker and were trading with “100:1 and 200:1 leverage”, not understanding what they are doing.
In reality the broker simply said “we will allow you to lever your margin up to 100:1, 200:1 or 400:1 at the absolute maximum, if you utilized all your borrowing power with us.”
But you must remember leverage is a double-edged sword. It can work for you and against you. And so a race started amongst the forex losers out there: where were the highest leverage, lowest margin and narrowest spreads being offered? As if this lethal combination would contribute to success...
So if you go to your friendly broker who offers both 100K lots and 10K mini lots you will find that on 100K lots you usually have a maximum of 100:1 leverage and on mini accounts 200:1 or 400:1.
So that is from the angle of the forex broker: They will allow maximum leverage of 100:1, 200:1, 400:1.
Vital for the trader: Minimum leverage needed
How does leverage look from your (the trader’s) side?
The question from your side is: How much margin do I need to trade a transaction of a certain value? The answer is simple, if they offer that I can lever my funds 100 times, then it is 1 / 100 = 1%, 1 /200 = 0.5%, 1/ 400 = 0.25%.
If we return to the stock market example the question of minimum leverage doesn’t play a role because if you have limited funds it would be prudent to buy low priced stocks in order to be able to invest in a basket of stocks.
But in the forex market where the minimum transaction values were initially 100K or 10K and a shell-shocked online trading public were lured to utilize the “advantages” of the high leverage with accounts of just $2,000 - $3,000 or mini accounts of $200 - $300, the minimum leverage certainly played a role.
To make all of this stick better I am going to use a real example:
A few years ago a now defunct tip service company did a survey on the typical forex trading account trading with 100K lots. The average sized account was an account of $6,000.
There is no question that the average trader will have to borrow money from the broker, ie leverage his funds. The question is “how much”? To do a minimum transaction of 100,000 you divide the 100,000 by 6,000 and there is the answer: 100,000 / 6,000 = 16.67.
In other words, he must borrow 16.67 times his money to do a minimum transaction and thus utilize a minimum leverage of 16.67:1. Just to do one silly trade.
Trading successfully: Know your real leverage
I am not going to be too technical about the exact leverage in these examples.
In reality if you have a US dollar account you should express the transaction value in US dollars before you calculate the exact leverage. So if you trade 100,000 GBPUSD, you actually trade dollars to the value of £100,000 which is at time of writing about $190,000. There is a big difference between $100,000 and $190,000. (As Warren Buffet said: Risk is not knowing what you are doing …)
With the flexibility offered by mini lots (10K), micro lots (1K) and variable lots (any size the trader defines) it is easier these days to determine one’s real leverage because you operate within the extremes of minimum leverage and maximum leverage.
Let’s return to the questions above:
Can you provide me with the information where I can get 1:1 leverage with the company you mention on page 108 of your book? I'm using a demo with only $1500 in the account with 200:1 leverage and I'm a bit worried about this even on 1 mini contract with one currency.
“Can you provide me with the information where I can get 1:1 leverage?”
Considering that leverage is transaction value divided by capital the important aspect is your capital and the minimum position size because to be in a position to trade 1:1 you must have at least the same capital as the minimum transaction. In your case you will have to trade with a broker that offers variable lots or micro lots not larger than 1,500 units.
“I'm using a demo with only $1500 in the account with 200:1 leverage”
You refer here to the maximum leverage or the maximum amount they will allow you to borrow. This is a fixed amount (percentage) applicable to all transactions and it does not affect your transactions at all, as long as you stay within this limit.
“I'm a bit worried about this even on 1 mini contract with one currency.”
First of all there is no need to worry about the “200;1 leverage”. It simply means it is the maximum you are allowed to trade, not what you are forced to trade (it’s your choice!). To trade the maximum would really be silly. Your real leverage if you trade one mini contract with $1,500 will be in the region of 6:1 or 7:1. (10,000 / 1,500).
It is interesting that you mention one currency also, because you must know that if you simultaneously trade 2 or 3 currencies your leverage increases. Say you trade one mini lot EURUSD, GBPUSD and USDCHF, the total value of units = 30,000 (3 mini lots) and your capital is still $1,500.
Your leverage is thus 30,000 / 1,500 = 20:1. That’s high. You borrow 20 times what you have.
To trade forex profitably you need a $3.00
calculator not $300.00 a month charting service.
Here is the proof:
Let’s talk about the 200:1 “leverage”.
I hope by now you understand that this refers to the maximum the marketing wizard will allow you to borrow and that you can borrow much less to keep your leverage sane and your account afloat. But if you go to that extreme you must be really desperate or stupid and for all practical purposes you are already on the way out.
So what the forex marketing wizards call “leverage” is actually the margin requirement expressed as a ratio instead of as a percentage, which makes more sense and has absolutely no impact on your trading, unless you are already basically wiped out or about to be.
Let’s say a trader has $10,000 and trades at a broker which offers “flexible leverage”.
You can choose your “leverage”, 400:1, 200:1, 100:1 or 50:1. What they mean is you can choose your margin requirement (which will define the maximum you can borrow from them) to be 0.25%, 0.5%, 1% or 2% of the transaction value.
Trader decides to buy 5 mini lots EURUSD, ie €50,000 transaction value and the value of one pip on this transaction is $5.00. Let’s say he makes 100 pips profit which is $500 or 5% of his capital.
Does the flexible margin requirement, generally called “leverage” affect this outcome?
The answer is “no”.
#
Leverage = 400:1 = 0.25% = $25 X 5 = $125. After 100 pips move the Trader makes $500.
#
Leverage = 200:1 = 0.50% = $50 X 5 = $250. After 100 pips move the Trader makes $500.
#
Leverage = 100:1 = 1.00% = $100 X 5 = $500. After 100 pips move the Trader makes $500.
#
Leverage = 50:1 = 2.00% = $200 X 5 = $1000. After 100 pips move the Trader makes $500.
It is vitally important that you grasp this:
The only variable in this whole trading exercise is the real leverage, not the margin requirement.
In the example above the market moved 100 pips irrespective of the margin required.
The only differentiating factor is how much the trader borrows out of what is available. Depending on how much trader borrows he will have a different outcome.
In the example he borrowed 5 times his capital, was levered 5:1 and made $500.00. If he borrowed ten times his capital and was levered 10:1, he would have made on the same market move $1,000 or 10% of his capital. If he borrowed two times his capital 2:1, 2% and so on.
Margin – Leverage - Risk
People incorrectly think the risk they take has to do with the margin requirement, forex marketing wizard’s “leverage”.
How many times have you come across money management or risk management systems that say you must not risk more than x% of your capital on a trade?
Let’s say our Trader used this technique and he doesn’t “risk more than 10% of his capital” on a trade.
In the example above in the case of 2% margin (50:1 “leverage”) the Trader “uses” 10% of his capital (as margin). (Hopefully you now realize that in reality he risks his capital 10 times!)
So if the approach is that the risk is determined in terms of the margin that is being “put up” on a per trade basis the following applies: Out with the calculators!
Trader has $10,000 and is prepared to "risk 10%"
#
Leverage = 400:1 = 0.25% 10 / .25 = 40. That is, 10% “risk” will be 40 lots or 400K. Real leverage = 400 / 10,000 = 40:1. Pip value = $40.00.
#
Leverage = 200:1 = 0.50% 10 / .50 = 20. That is, 10% “risk” will be 20 lots or 200K. Real leverage = 200 / 10,000 = 20:1. Pip value = $20.00
#
Leverage = 100:1 = 1.00% 10 / 1.00 = 10. That is, 10% “risk” will be 10 lots or 100K. Real leverage = 100 / 10,000 = 10:1. Pip value = $10.00
#
Leverage = 50:1 = 2.00% 10 / 2.00 = 5. That is, 10% “risk” will be 5 lots or 50K. Real leverage = 50 / 10,000 = 5:1. Pip value = $5.00
This same risk management strategy then usually says, don’t risk more than x% of your capital in potential losses, therefore calculate your stop-loss point beforehand as a percentage of capital. So a stop-loss is typically set at 2% or 3% of capital.
In this case, if 2%, the maximum loss value will be $200 (2% of capital of $10,000). But as you have seen now, the first part incorrectly calculates pip value based on a bogus principle (for the leveraged trader), while the trader supposedly “risks” 10% of his capital in all four cases.
#
Leverage = 400:1, Pip value = $40.00, “risk 10%”. The stop-loss of 2% must be 5 pips.
#
Leverage = 200:1, Pip value = $20.00, “risk 10%”. The stop-loss of 2% must be 10 pips.
#
Leverage = 100:1, Pip value = $10.00, “risk 10%”. The stop-loss of 2% must be 20 pips.
#
Leverage = 50:1, Pip value = $5.00, “risk 10%”. The stop-loss of 2% must be 40 pips.
The above clearly demonstrates that a misunderstanding of leverage can be devastating to your chances of success.
It also demonstrates that many so-called money management systems are absolutely bogus - spreadsheet theory - and have nothing to do with real profitable trading.
Suffice it to say that while the “400:1 and 200:1” options aren’t utilized that much you will be tempted by the 100:1 and 50:1 options as suggested by almost all the experts out there, accompanied by the necessary 20, 30 and 40 pip stops that are hit all the time (followed by the inevitable market movement in your initial anticipated direction).
Summary
#
What is usually referred to as leverage is actually the margin required expressed as a ratio if you use all the borrowing power the broker will allow.
#
Real leverage is determined by dividing your capital into the value of your positions.
#
Real leverage can differ from trade to trade and increases with multiple simultaneous trades.
#
Margin required has no influence on your risk if you trade properly with modest leverage within your means and is not to be used as a risk calculating principle.
Next time
Part 2 of “Leverage is not even a double-edged sword, it’s a guillotine”
Kind regards
Dirk D. du Toit
Leverage is not even a double-edged sword, it’s a guillotine - and your head is on the block – PART 1
Dr Forex says - Let me explain to you
once and for all that leverage is not what
brokers allow you to use, it is what you decide to use.
At long last I am at the point where my Bird Watching in Lion Country Newsletter is ready for publication. If you haven’t received one before, don’t start searching amongst your spam filter emails. This is the first newsletter.
Choice of topic is a difficult matter but “leverage” was always high on the priority list for the first issue. Recently I once again realized clearly how misunderstood this vital concept was to all aspects of forex. In my mind there is no doubt that most of the trouble that forex traders have starts with leverage.
I will dedicate this first newsletter then to this concept –
leverage and its destructive power in the retail forex trading world.
A few facts
#
Personally I have not seen one wiped out trading account that wasn’t leveraged too high.
#
I have also no record of any sustained profitable trading account based on high leveraged, short-stop trading.
#
I ask my mentoring clients early on what they believe are the reasons for previous losses. Most answers include something to do with leverage, not understanding it at all, or only partially, or underestimating it once they have understood it.
Leverage then, is …?
I get many questions, like the one below:
I'm reading your book and I'm really enjoying it. Can you provide me with the information where I can get 1:1 leverage with the company you mention on page 108 of your book? I'm using a demo with only $1500 in the account with 200:1 leverage and I'm a bit worried about this even on 1 mini contract with one currency.
Or:
I contacted the broker you suggested where I could trade with less than $10,000 with low leverage, but they only offer 50:1 leverage and not 3:1 like you suggest.
It is very clear that leverage is misunderstood and this misunderstanding is a root cause of forex trading losses and the futile attempts to overcome these losses without addressing the root cause.
Regulatory warnings that leverage is a double-edged sword that can work for or against you go completely unheeded, just as the warning “past performance is no indication of future performance” is flatly ignored.
Leverage is largely misunderstood because the marketing wizards of forex (your friendly forex broker) have done a slight-of-hand trick that shifted the focus from the very important fact of how much the trader levers his trading capital to how much the forex marketing wizard is prepared to lend the trader.
Everything you read about leverage has to do with the maximum leverage you can achieve and very little about the prudent application of leverage in a forex trading system. In other words, the broker is telling you how much he will allow you to leverage, if you want to, not how much you should leverage, if you know better.
Warren Buffet said – “Risk is not knowing what you are doing”.
People speak about 100:1 leverage – “I trade with 100:1”, without knowing what it means. I will show below how you are your greatest enemy by being ignorant about this vital concept. I hope many of you will get a very important “AHA” experience from the newsletter.
Definition of leverage
This is a general definition:
The mechanical power or advantage gained through using a lever.
A definition found at www.investorwords.com says leverage is:
The degree to which an investor or business is utilizing borrowed money.
Closer to forex trading: www.thefreedictionary.com
The use of credit or borrowed funds to improve one's speculative capacity and increase the rate of return from an investment, as in buying securities on margin.
Enter the concept of “margin”. Let’s make sure we understand what margin is:
Definition of margin
The amount of collateral a customer deposits with a broker when borrowing from the broker to buy securities.
This is exactly what you do if you open a forex trading account. You deposit collateral in order to be able to borrow currencies to trade currencies. Actually you don’t have to borrow, but you can if you want to.
The moment that borrowing comes into play it is common knowledge that the amount that the lender will be prepared to lend has certain limitations. Obviously you can’t lend indefinite amounts.
The thing that stumps most traders is the fact that the marketing wizards use the terms “leverage” and “margin” very loosely and interchangeably. This causes a lot of confusion. I believe this is done deliberately because it is in the forex broker’s interest that traders do not see high leverage as a destructive problem but as an opportunity.
Let’s make sure we understand first “leverage” and then “margin”.
To understand leverage properly for trading purposes, let’s use a well-known concept. You want to buy a house, you don’t have the capital available, but you have a salary and can pay instalments on a regular basis, so you go to the bank and borrow money to pay for the house. So you are leveraging your income / salary.
There are limitations based on, amongst others, your income which means the amount you can borrow based on your income will be limited. There is a maximum you can borrow. Obvious, yes, but a very important concept for the lender – the maximum he should lend you in order to get the maximum return on his capital without overexposing himself to risk of default on your side.
(Just a thought from the sideline. If trading forex is mostly with borrowed funds why don’t the brokers ask interest? Think about that …. )
Remember this: The lender is focused on maximums whereas the borrower should be concerned with minimums - borrowing as little as he can but still getting bang for his buck.
Now we turn to your trading account: you want to increase your speculative capacity by leveraging your investment, therefore you borrow money to trade with from your broker.
Before your broker will lend you money you have to put down margin, which you wish to lever. Your broker, being a prudent businessman has calculated his risk beforehand and is quick to tell you what the maximum is he will allow you to borrow from him. In forex it is typically one hundred times your capital but it can also be two hundred times your capital or even four hundred times your capital. This is one part of the equation:
“Dear valued customer, you will be able to leverage your money 100:1, (200:1, 400;1). We hope we can have a long and mutually beneficial relationship.”
The other side of the equation is how much of this available borrowing you want to utilize in your speculative endeavours.
How much leverage you apply is your own decision
and not something the broker can force on to you.
Here is proof:
We are going to start with a stock market example.
You open a trading account with a stockbroker, with say, $10,000. You can buy stocks to the value of $10,000. Let’s say you did. Did you leverage your funds?
No. You didn’t borrow a cent from the broker. You have $10,000 and the value of your stocks when you purchased them was $10,000 (ignore costs for the moment).
How do you calculate your leverage?
You divide your capital into the value of your transaction and express it as a ratio of “value of transaction” : “capital”.
In the above example you divide $10,000 / $10,000 = 1:1
Well, your friendly online stockbroker one day sends you a message that they now allow margined trading and you can borrow funds to purchase stock up to the value of your current stocks. For simplicity sake we say the value of your stocks is still $10,000. In other words you can now buy another $10,000 worth of stocks while your capital input remains $10,000.
You do this after you just received a hot tip and now you have a transaction value of 2 X $10,000 = $20,000 divided by your capital of $10,000 = leverage of 2:1. Or you can choose not to, it depends on you.
Vital for the broker: Maximum leverage allowed
The maximum leverage you can apply (as opposed to how much you want to apply) is your broker’s decision:
The important thing you have to note in the above example is that you have utilized all the leverage you were allowed by the broker. This is vital. The broker takes a huge risk to lend you money and therefore they have certain rules which you must adhere to. There is a limit to what you can borrow from them. In the above example the limit is leverage of 2:1 or seen from another viewpoint margin of 50%. You must have at least half the value of your total transaction available in margin (in other words collateral in case you aren’t as hot a trader as you thought).
Margin is usually expressed as a percentage, while leverage is expressed as a ratio.
The marketing wizards of forex realized that the fact that they can offer very high leverage will be to their advantage to lure online investors from the traditional markets. Furthermore, many online investors’ portfolios were devastated by the 2000 crash and losses of up to 90% of formerly lucrative stock portfolios became commonplace – much of this leveraged through stock option schemes.
As a result they started to tout from the rooftops that leverage of 100:1, 200:1, and with the introduction of mini accounts, even 400:1 and 500:1 was available.
Terms like “trade with 100:1” leverage became the order of the day.
An unsuspecting and clueless online trading public swallowed this hook, line and sinker and were trading with “100:1 and 200:1 leverage”, not understanding what they are doing.
In reality the broker simply said “we will allow you to lever your margin up to 100:1, 200:1 or 400:1 at the absolute maximum, if you utilized all your borrowing power with us.”
But you must remember leverage is a double-edged sword. It can work for you and against you. And so a race started amongst the forex losers out there: where were the highest leverage, lowest margin and narrowest spreads being offered? As if this lethal combination would contribute to success...
So if you go to your friendly broker who offers both 100K lots and 10K mini lots you will find that on 100K lots you usually have a maximum of 100:1 leverage and on mini accounts 200:1 or 400:1.
So that is from the angle of the forex broker: They will allow maximum leverage of 100:1, 200:1, 400:1.
Vital for the trader: Minimum leverage needed
How does leverage look from your (the trader’s) side?
The question from your side is: How much margin do I need to trade a transaction of a certain value? The answer is simple, if they offer that I can lever my funds 100 times, then it is 1 / 100 = 1%, 1 /200 = 0.5%, 1/ 400 = 0.25%.
If we return to the stock market example the question of minimum leverage doesn’t play a role because if you have limited funds it would be prudent to buy low priced stocks in order to be able to invest in a basket of stocks.
But in the forex market where the minimum transaction values were initially 100K or 10K and a shell-shocked online trading public were lured to utilize the “advantages” of the high leverage with accounts of just $2,000 - $3,000 or mini accounts of $200 - $300, the minimum leverage certainly played a role.
To make all of this stick better I am going to use a real example:
A few years ago a now defunct tip service company did a survey on the typical forex trading account trading with 100K lots. The average sized account was an account of $6,000.
There is no question that the average trader will have to borrow money from the broker, ie leverage his funds. The question is “how much”? To do a minimum transaction of 100,000 you divide the 100,000 by 6,000 and there is the answer: 100,000 / 6,000 = 16.67.
In other words, he must borrow 16.67 times his money to do a minimum transaction and thus utilize a minimum leverage of 16.67:1. Just to do one silly trade.
Trading successfully: Know your real leverage
I am not going to be too technical about the exact leverage in these examples.
In reality if you have a US dollar account you should express the transaction value in US dollars before you calculate the exact leverage. So if you trade 100,000 GBPUSD, you actually trade dollars to the value of £100,000 which is at time of writing about $190,000. There is a big difference between $100,000 and $190,000. (As Warren Buffet said: Risk is not knowing what you are doing …)
With the flexibility offered by mini lots (10K), micro lots (1K) and variable lots (any size the trader defines) it is easier these days to determine one’s real leverage because you operate within the extremes of minimum leverage and maximum leverage.
Let’s return to the questions above:
Can you provide me with the information where I can get 1:1 leverage with the company you mention on page 108 of your book? I'm using a demo with only $1500 in the account with 200:1 leverage and I'm a bit worried about this even on 1 mini contract with one currency.
“Can you provide me with the information where I can get 1:1 leverage?”
Considering that leverage is transaction value divided by capital the important aspect is your capital and the minimum position size because to be in a position to trade 1:1 you must have at least the same capital as the minimum transaction. In your case you will have to trade with a broker that offers variable lots or micro lots not larger than 1,500 units.
“I'm using a demo with only $1500 in the account with 200:1 leverage”
You refer here to the maximum leverage or the maximum amount they will allow you to borrow. This is a fixed amount (percentage) applicable to all transactions and it does not affect your transactions at all, as long as you stay within this limit.
“I'm a bit worried about this even on 1 mini contract with one currency.”
First of all there is no need to worry about the “200;1 leverage”. It simply means it is the maximum you are allowed to trade, not what you are forced to trade (it’s your choice!). To trade the maximum would really be silly. Your real leverage if you trade one mini contract with $1,500 will be in the region of 6:1 or 7:1. (10,000 / 1,500).
It is interesting that you mention one currency also, because you must know that if you simultaneously trade 2 or 3 currencies your leverage increases. Say you trade one mini lot EURUSD, GBPUSD and USDCHF, the total value of units = 30,000 (3 mini lots) and your capital is still $1,500.
Your leverage is thus 30,000 / 1,500 = 20:1. That’s high. You borrow 20 times what you have.
To trade forex profitably you need a $3.00
calculator not $300.00 a month charting service.
Here is the proof:
Let’s talk about the 200:1 “leverage”.
I hope by now you understand that this refers to the maximum the marketing wizard will allow you to borrow and that you can borrow much less to keep your leverage sane and your account afloat. But if you go to that extreme you must be really desperate or stupid and for all practical purposes you are already on the way out.
So what the forex marketing wizards call “leverage” is actually the margin requirement expressed as a ratio instead of as a percentage, which makes more sense and has absolutely no impact on your trading, unless you are already basically wiped out or about to be.
Let’s say a trader has $10,000 and trades at a broker which offers “flexible leverage”.
You can choose your “leverage”, 400:1, 200:1, 100:1 or 50:1. What they mean is you can choose your margin requirement (which will define the maximum you can borrow from them) to be 0.25%, 0.5%, 1% or 2% of the transaction value.
Trader decides to buy 5 mini lots EURUSD, ie €50,000 transaction value and the value of one pip on this transaction is $5.00. Let’s say he makes 100 pips profit which is $500 or 5% of his capital.
Does the flexible margin requirement, generally called “leverage” affect this outcome?
The answer is “no”.
#
Leverage = 400:1 = 0.25% = $25 X 5 = $125. After 100 pips move the Trader makes $500.
#
Leverage = 200:1 = 0.50% = $50 X 5 = $250. After 100 pips move the Trader makes $500.
#
Leverage = 100:1 = 1.00% = $100 X 5 = $500. After 100 pips move the Trader makes $500.
#
Leverage = 50:1 = 2.00% = $200 X 5 = $1000. After 100 pips move the Trader makes $500.
It is vitally important that you grasp this:
The only variable in this whole trading exercise is the real leverage, not the margin requirement.
In the example above the market moved 100 pips irrespective of the margin required.
The only differentiating factor is how much the trader borrows out of what is available. Depending on how much trader borrows he will have a different outcome.
In the example he borrowed 5 times his capital, was levered 5:1 and made $500.00. If he borrowed ten times his capital and was levered 10:1, he would have made on the same market move $1,000 or 10% of his capital. If he borrowed two times his capital 2:1, 2% and so on.
Margin – Leverage - Risk
People incorrectly think the risk they take has to do with the margin requirement, forex marketing wizard’s “leverage”.
How many times have you come across money management or risk management systems that say you must not risk more than x% of your capital on a trade?
Let’s say our Trader used this technique and he doesn’t “risk more than 10% of his capital” on a trade.
In the example above in the case of 2% margin (50:1 “leverage”) the Trader “uses” 10% of his capital (as margin). (Hopefully you now realize that in reality he risks his capital 10 times!)
So if the approach is that the risk is determined in terms of the margin that is being “put up” on a per trade basis the following applies: Out with the calculators!
Trader has $10,000 and is prepared to "risk 10%"
#
Leverage = 400:1 = 0.25% 10 / .25 = 40. That is, 10% “risk” will be 40 lots or 400K. Real leverage = 400 / 10,000 = 40:1. Pip value = $40.00.
#
Leverage = 200:1 = 0.50% 10 / .50 = 20. That is, 10% “risk” will be 20 lots or 200K. Real leverage = 200 / 10,000 = 20:1. Pip value = $20.00
#
Leverage = 100:1 = 1.00% 10 / 1.00 = 10. That is, 10% “risk” will be 10 lots or 100K. Real leverage = 100 / 10,000 = 10:1. Pip value = $10.00
#
Leverage = 50:1 = 2.00% 10 / 2.00 = 5. That is, 10% “risk” will be 5 lots or 50K. Real leverage = 50 / 10,000 = 5:1. Pip value = $5.00
This same risk management strategy then usually says, don’t risk more than x% of your capital in potential losses, therefore calculate your stop-loss point beforehand as a percentage of capital. So a stop-loss is typically set at 2% or 3% of capital.
In this case, if 2%, the maximum loss value will be $200 (2% of capital of $10,000). But as you have seen now, the first part incorrectly calculates pip value based on a bogus principle (for the leveraged trader), while the trader supposedly “risks” 10% of his capital in all four cases.
#
Leverage = 400:1, Pip value = $40.00, “risk 10%”. The stop-loss of 2% must be 5 pips.
#
Leverage = 200:1, Pip value = $20.00, “risk 10%”. The stop-loss of 2% must be 10 pips.
#
Leverage = 100:1, Pip value = $10.00, “risk 10%”. The stop-loss of 2% must be 20 pips.
#
Leverage = 50:1, Pip value = $5.00, “risk 10%”. The stop-loss of 2% must be 40 pips.
The above clearly demonstrates that a misunderstanding of leverage can be devastating to your chances of success.
It also demonstrates that many so-called money management systems are absolutely bogus - spreadsheet theory - and have nothing to do with real profitable trading.
Suffice it to say that while the “400:1 and 200:1” options aren’t utilized that much you will be tempted by the 100:1 and 50:1 options as suggested by almost all the experts out there, accompanied by the necessary 20, 30 and 40 pip stops that are hit all the time (followed by the inevitable market movement in your initial anticipated direction).
Summary
#
What is usually referred to as leverage is actually the margin required expressed as a ratio if you use all the borrowing power the broker will allow.
#
Real leverage is determined by dividing your capital into the value of your positions.
#
Real leverage can differ from trade to trade and increases with multiple simultaneous trades.
#
Margin required has no influence on your risk if you trade properly with modest leverage within your means and is not to be used as a risk calculating principle.
Next time
Part 2 of “Leverage is not even a double-edged sword, it’s a guillotine”
Kind regards
Dirk D. du Toit
Technical Indicators In Forex Trading - Understanding Their Limitations
Forex traders often look at indicators such as Bollinger Bands, Pivot Points, MACD, Moving Averages and the such to help them determine where to enter or exit trades. Using technical indicators is fine, however many traders overemphasize their importance or just plain misunderstand them.
Many forex traders think that they can simply download an indicator and then mechanically apply it into their trading and do so profitably. This is just a plain illusion. Successful traders realize that there is a lot more to using indicators than just asking them to generate buy/sell signals or pin-point exact entry points. Technical indicators for them represent just one part of their trading strategy.
Let¡¯s take a look at some of the reasons why you should not put all your faith into those sometimes confusing little indicators.
Take Moving Averages (MA¡¯s) for example. They are "supposed" to show the direction of the trend. The most common and often used are the simple 200day MA, 100day MA, 50day MA, 35day MA and the 21day MA but they are only valid on daily graphs. Some forex day traders say that a good signal is when the 50day MA is crossed by the 13day MA and that when this occurs you should trade in the direction of the cross.
The problem with this (apart from the fact that it only works on daily graphs) is that these types of ¡°crosses¡± do not occur often enough for traders to exploit them. This can often lead to a situation where traders are seeing what they thought was a cross now reverse and uncross. Even worse, it can lead to a situation where day traders are "chasing" and trying to anticipate a cross. If you are doing this, you are distancing yourself from the market which you are trying to trade. Not only are you trying to guess what the price is going to do next but you are guessing what the indicator, based on the prices, is going to do next.
Other problems with technical indicators involve issues with the quotes and prices given to you by your broker. Forex brokers are market makers and as such different brokers will give you different quotes and prices at a specific point in time. Naturally, a different price could lead to a situation where different traders, trading the same market have the same indicators giving them different responses. That¡¯s how arbitrary technical indicators can be.
Finally, a lot of these technical indicators were developed by people trading the stock market. With the growth of computers and software packages that incorporate these indicators, technical analysis has become very popular and spread to other markets such as the forex market. What currency traders should be aware of however, is that as these indicators were developed in a time where real time information did not exist. As such, the limitations of technical analysis becomes even more exaggerated in forex trading ¨C not only is technical analysis an interpretation of historical events but it becomes even more so in the forex market, a market moved by real time events.
Conclusion:
Successful forex traders understand the limitations of technical indicators and realize that technical analysis should incorporate just one part of their trading strategy. In a recent international Forex market event visited by the major banks and institutions - the main players that influence the foreign currency market ¨C a survey was done to better understand what analysis they use. The results might be surprising to some tarders. The survey showed that a mere 26% use technical analysis and indicators compared to 41% who said they use fundamental analysis.
About the Author
Jovan Vucetic is the Editor of Margin Strategies, an educational forex website, which reviews forex trading systems. Learn about different types of forex trading strategies including a purely mechanical trading system which does not require interpretation of the usual Technical Indicators.
Posted by adry
Many forex traders think that they can simply download an indicator and then mechanically apply it into their trading and do so profitably. This is just a plain illusion. Successful traders realize that there is a lot more to using indicators than just asking them to generate buy/sell signals or pin-point exact entry points. Technical indicators for them represent just one part of their trading strategy.
Let¡¯s take a look at some of the reasons why you should not put all your faith into those sometimes confusing little indicators.
Take Moving Averages (MA¡¯s) for example. They are "supposed" to show the direction of the trend. The most common and often used are the simple 200day MA, 100day MA, 50day MA, 35day MA and the 21day MA but they are only valid on daily graphs. Some forex day traders say that a good signal is when the 50day MA is crossed by the 13day MA and that when this occurs you should trade in the direction of the cross.
The problem with this (apart from the fact that it only works on daily graphs) is that these types of ¡°crosses¡± do not occur often enough for traders to exploit them. This can often lead to a situation where traders are seeing what they thought was a cross now reverse and uncross. Even worse, it can lead to a situation where day traders are "chasing" and trying to anticipate a cross. If you are doing this, you are distancing yourself from the market which you are trying to trade. Not only are you trying to guess what the price is going to do next but you are guessing what the indicator, based on the prices, is going to do next.
Other problems with technical indicators involve issues with the quotes and prices given to you by your broker. Forex brokers are market makers and as such different brokers will give you different quotes and prices at a specific point in time. Naturally, a different price could lead to a situation where different traders, trading the same market have the same indicators giving them different responses. That¡¯s how arbitrary technical indicators can be.
Finally, a lot of these technical indicators were developed by people trading the stock market. With the growth of computers and software packages that incorporate these indicators, technical analysis has become very popular and spread to other markets such as the forex market. What currency traders should be aware of however, is that as these indicators were developed in a time where real time information did not exist. As such, the limitations of technical analysis becomes even more exaggerated in forex trading ¨C not only is technical analysis an interpretation of historical events but it becomes even more so in the forex market, a market moved by real time events.
Conclusion:
Successful forex traders understand the limitations of technical indicators and realize that technical analysis should incorporate just one part of their trading strategy. In a recent international Forex market event visited by the major banks and institutions - the main players that influence the foreign currency market ¨C a survey was done to better understand what analysis they use. The results might be surprising to some tarders. The survey showed that a mere 26% use technical analysis and indicators compared to 41% who said they use fundamental analysis.
About the Author
Jovan Vucetic is the Editor of Margin Strategies, an educational forex website, which reviews forex trading systems. Learn about different types of forex trading strategies including a purely mechanical trading system which does not require interpretation of the usual Technical Indicators.
Posted by adry
Fundamental Analysis On Forex Trading
It has become imperative for every forex trader to learn how to predict the price trend and which method or software is the best.
When you do forex trading, it is very important to understand the difference between fundamental analysis and technical analysis. A quick explanation of the difference among the two types of analysis is: fundamental analysis focuses on money policy, government policy and economic indicators such as GDP, exports, imports etc within a business cycle framework while technical analysis focuses on price action and market behavior, especially on chart and technical indicators.
Needless to say both schools are equally disparaging about the other, and both believe their techniques are infinitely superior. But the reality is that it has become increasingly difficult to be a purist of either persuasion. Fundamentalists need to keep an eye on the various signals derived from the price action on charts, while few technicians can afford to completely ignore impending economic data, critical political decisions or the myriad of societal issues that influence prices.
Generally speaking, fundamental analysis can only judge which direction the market will move, and technical analysis can supply both direction and rough currency rate.
Keeping in mind that the financial underpinnings of any country, trading bloc or multinational industry takes into account many factors, including social, political and economic influences, staying on top of an extremely fluid fundamental picture can be challenging. Meanwhile, forecasting models are as numerous and varied as the traders and market buffs that create them. Different people can look at the exact same data and come up with two completely different conclusions about how the market will be influenced by it. At the end, some may make huge profit and some lose their money. You can not say fundamental analysis is easy.
Remember, fundamental analysis is a very effective way to forecast economic conditions, but not necessarily exact market prices. For example, when analyzing an economist's forecast of the upcoming GDP or employment report, you begin to get a fairly clear picture of the general health of the economy and the forces at work behind it. However, you'll need to come up with a precise method as to how best to translate this information into entry and exit points for a particular trading strategy.
Tip: If you are new to do forex trading and do not trade frequently, you can mainly use fundamental analysis for your trading.
Don't disturb yourself by information overload. Sometimes traders fall into this trap and are unable to pull the trigger on a trade. Normally, your first feel is the answer for you to do forex trading. At that time, you are sure which currency is strong and which country's economy is good. The more simple, the more useful.
However, trading a particular market without knowing a great deal about the exact nature of its underlying elements is unbelievable. You might get lucky and snare a few on occasion but it's not the best approach over the long haul.
For forex traders, the fundamentals are everything that makes a country tick. From interest rates and central bank policy to natural disasters, the fundamentals are a dynamic mix of distinct plans, erratic behaviors and unforeseen events. Therefore, it is very important to understand fundamental analysis and use them on forex trading.
About the Author
Paul Zou is the blogger of Make Money Online, Online Investment and Work At Home. Featured information for you to work at home and make money online. You can contact him at email:paulzou@yahoo.com
Forex eBooks
When you do forex trading, it is very important to understand the difference between fundamental analysis and technical analysis. A quick explanation of the difference among the two types of analysis is: fundamental analysis focuses on money policy, government policy and economic indicators such as GDP, exports, imports etc within a business cycle framework while technical analysis focuses on price action and market behavior, especially on chart and technical indicators.
Needless to say both schools are equally disparaging about the other, and both believe their techniques are infinitely superior. But the reality is that it has become increasingly difficult to be a purist of either persuasion. Fundamentalists need to keep an eye on the various signals derived from the price action on charts, while few technicians can afford to completely ignore impending economic data, critical political decisions or the myriad of societal issues that influence prices.
Generally speaking, fundamental analysis can only judge which direction the market will move, and technical analysis can supply both direction and rough currency rate.
Keeping in mind that the financial underpinnings of any country, trading bloc or multinational industry takes into account many factors, including social, political and economic influences, staying on top of an extremely fluid fundamental picture can be challenging. Meanwhile, forecasting models are as numerous and varied as the traders and market buffs that create them. Different people can look at the exact same data and come up with two completely different conclusions about how the market will be influenced by it. At the end, some may make huge profit and some lose their money. You can not say fundamental analysis is easy.
Remember, fundamental analysis is a very effective way to forecast economic conditions, but not necessarily exact market prices. For example, when analyzing an economist's forecast of the upcoming GDP or employment report, you begin to get a fairly clear picture of the general health of the economy and the forces at work behind it. However, you'll need to come up with a precise method as to how best to translate this information into entry and exit points for a particular trading strategy.
Tip: If you are new to do forex trading and do not trade frequently, you can mainly use fundamental analysis for your trading.
Don't disturb yourself by information overload. Sometimes traders fall into this trap and are unable to pull the trigger on a trade. Normally, your first feel is the answer for you to do forex trading. At that time, you are sure which currency is strong and which country's economy is good. The more simple, the more useful.
However, trading a particular market without knowing a great deal about the exact nature of its underlying elements is unbelievable. You might get lucky and snare a few on occasion but it's not the best approach over the long haul.
For forex traders, the fundamentals are everything that makes a country tick. From interest rates and central bank policy to natural disasters, the fundamentals are a dynamic mix of distinct plans, erratic behaviors and unforeseen events. Therefore, it is very important to understand fundamental analysis and use them on forex trading.
About the Author
Paul Zou is the blogger of Make Money Online, Online Investment and Work At Home. Featured information for you to work at home and make money online. You can contact him at email:paulzou@yahoo.com
Forex eBooks
How to take a loss
Brett N. Steenbarger, Ph.D.
There are quite a few books written on how to make money in the market. Some of them are even written by people who have made money as traders! What you don't see often, however, are books or articles written on how to lose money. “Cut your losers and let your winners run” is commonsensical advice, but how do you determine when a position is a loser? Interestingly, most traders I have seen don't formulate an answer to this question when they put on a position. They focus on the entry, but then don't have a clear sense of exit—especially if that exit is going to put them into the red.
One of the real culprits, I have to believe, is in the difficulty traders have in separating the reality of a losing trade from the psychological sense of feeling like a loser. At some level, many traders equate losing with being a loser. This frustrates them, depresses them, makes them anxious—in short, it interferes with their future decision-making, because their P & L is a blank check written against their self-esteem. Once a trader is self-focused and not market focused, distortions in decision-making are inevitable.
A particularly valuable section of the classic book Reminiscences of a Stock Operator describes Livermore 's approach to buying stock. He would sell a quantity and see how the stock responded. Then he would do that again and again, testing the underlying demand for the issue. When his sales could not push the market down, then he would move aggressively to the buy side and make his money.
What I loved about this methodology is that Livermore's losses were part of a grander plan. He wasn't just losing money; he was paying for information. If my maximum position size is ten contracts in the ES and I buy the highs of a range with a one-lot, expecting a breakout, I am testing the waters. While I am not potentially moving the market in the way that Livermore might have, I still have begun a test of my breakout hypothesis. I then watch carefully. How are the other averages behaving at the top ends of their range? How is the market absorbing the activity of sellers? Like any good scientist, I am gathering data to determine whether or not my hypothesis is supported.
Suppose the breakout does not materialize and the initial move above the range falls back into the range on some increased selling pressure. I take the loss on my one-lot, but then what happens from there?
The unsuccessful trader will respond with frustration: “Why do I always get caught buying the highs? I can't believe “they” ran the market against me! This market is impossible to trade.” Because of that frustration—and the associated self-focus—the unsuccessful trader does not take any information away from that trade.
In the Livermore mode, however, the successful trader will see the losing one-lot as part of a greater plan. Had the market broken nicely to the upside, he would have scaled into the long trade and likely made money. If the one-lot was a loser, he paid for the information that this is, at the very least, a range-bound market, and he might try to find a spot to reverse and go short in order to capitalize on a return to the bottom end of that range.
Look at it this way: If you put on a high probability trade and the trade fails to make you money, you have just paid for an important piece of information: The market is not behaving as it normally, historically does. If a robust piece of economic news that normally sends the dollar screaming higher fails to budge the currency and thwarts your purchase, you have just acquired a useful bit of information: There is an underlying lack of demand for dollars. That information might hold far more profit potential than the money lost in the initial trade.
I recently received a copy of an article from Futures Magazine on the retired trader Everett Klipp, who was dubbed the “Babe Ruth of the CBOT”. Klipp distinguished himself not only by his fifty-year track record of trading success on the floor, but also by his mentorship of over 100 traders. Speaking of his system of short-term trading, Klipp observed, “You have to love to lose money and hate to make money to be successful…It's against human nature what I teach and practice. You have to overcome your humanness.”
Klipp's system was quick to take profits (hence the idea of hating to make money), but even quicker to take losses (loving to lose money). Instead of viewing losses as a threat, Klipp treated them as an essential part of trading. Taking a small loss reinforces a trader's sense of discipline and control, he believed. Losses are not failures.
So here's a question I propose to all those who enter a high-probability trade: “What will tell me that my trade is wrong, and how could I use that information to subsequently profit?” If you're trading well, there are no losing trades: only trades that make money and trades that give you the information to make money later.
Brett N. Steenbarger, Ph.D. is Director of Trader Development for Kingstree Trading, LLC in Chicago and Clinical Associate Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY. He is also an active trader and writes occasional feature articles on market psychology for a variety of publications. The author of The Psychology of Trading (Wiley; January, 2003), Dr. Steenbarger has published over 50 peer-reviewed articles and book chapters on short-term approaches to behavioral change. His new, co-edited book The Art and Science of Brief Therapy is a core curricular text in psychiatry training programs. Many of Dr. Steenbarger's articles and trading strategies are archived on his website, www.brettsteenbarger.com
STRAIGHT FOREX © 2005, 2006, 2007
There are quite a few books written on how to make money in the market. Some of them are even written by people who have made money as traders! What you don't see often, however, are books or articles written on how to lose money. “Cut your losers and let your winners run” is commonsensical advice, but how do you determine when a position is a loser? Interestingly, most traders I have seen don't formulate an answer to this question when they put on a position. They focus on the entry, but then don't have a clear sense of exit—especially if that exit is going to put them into the red.
One of the real culprits, I have to believe, is in the difficulty traders have in separating the reality of a losing trade from the psychological sense of feeling like a loser. At some level, many traders equate losing with being a loser. This frustrates them, depresses them, makes them anxious—in short, it interferes with their future decision-making, because their P & L is a blank check written against their self-esteem. Once a trader is self-focused and not market focused, distortions in decision-making are inevitable.
A particularly valuable section of the classic book Reminiscences of a Stock Operator describes Livermore 's approach to buying stock. He would sell a quantity and see how the stock responded. Then he would do that again and again, testing the underlying demand for the issue. When his sales could not push the market down, then he would move aggressively to the buy side and make his money.
What I loved about this methodology is that Livermore's losses were part of a grander plan. He wasn't just losing money; he was paying for information. If my maximum position size is ten contracts in the ES and I buy the highs of a range with a one-lot, expecting a breakout, I am testing the waters. While I am not potentially moving the market in the way that Livermore might have, I still have begun a test of my breakout hypothesis. I then watch carefully. How are the other averages behaving at the top ends of their range? How is the market absorbing the activity of sellers? Like any good scientist, I am gathering data to determine whether or not my hypothesis is supported.
Suppose the breakout does not materialize and the initial move above the range falls back into the range on some increased selling pressure. I take the loss on my one-lot, but then what happens from there?
The unsuccessful trader will respond with frustration: “Why do I always get caught buying the highs? I can't believe “they” ran the market against me! This market is impossible to trade.” Because of that frustration—and the associated self-focus—the unsuccessful trader does not take any information away from that trade.
In the Livermore mode, however, the successful trader will see the losing one-lot as part of a greater plan. Had the market broken nicely to the upside, he would have scaled into the long trade and likely made money. If the one-lot was a loser, he paid for the information that this is, at the very least, a range-bound market, and he might try to find a spot to reverse and go short in order to capitalize on a return to the bottom end of that range.
Look at it this way: If you put on a high probability trade and the trade fails to make you money, you have just paid for an important piece of information: The market is not behaving as it normally, historically does. If a robust piece of economic news that normally sends the dollar screaming higher fails to budge the currency and thwarts your purchase, you have just acquired a useful bit of information: There is an underlying lack of demand for dollars. That information might hold far more profit potential than the money lost in the initial trade.
I recently received a copy of an article from Futures Magazine on the retired trader Everett Klipp, who was dubbed the “Babe Ruth of the CBOT”. Klipp distinguished himself not only by his fifty-year track record of trading success on the floor, but also by his mentorship of over 100 traders. Speaking of his system of short-term trading, Klipp observed, “You have to love to lose money and hate to make money to be successful…It's against human nature what I teach and practice. You have to overcome your humanness.”
Klipp's system was quick to take profits (hence the idea of hating to make money), but even quicker to take losses (loving to lose money). Instead of viewing losses as a threat, Klipp treated them as an essential part of trading. Taking a small loss reinforces a trader's sense of discipline and control, he believed. Losses are not failures.
So here's a question I propose to all those who enter a high-probability trade: “What will tell me that my trade is wrong, and how could I use that information to subsequently profit?” If you're trading well, there are no losing trades: only trades that make money and trades that give you the information to make money later.
Brett N. Steenbarger, Ph.D. is Director of Trader Development for Kingstree Trading, LLC in Chicago and Clinical Associate Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY. He is also an active trader and writes occasional feature articles on market psychology for a variety of publications. The author of The Psychology of Trading (Wiley; January, 2003), Dr. Steenbarger has published over 50 peer-reviewed articles and book chapters on short-term approaches to behavioral change. His new, co-edited book The Art and Science of Brief Therapy is a core curricular text in psychiatry training programs. Many of Dr. Steenbarger's articles and trading strategies are archived on his website, www.brettsteenbarger.com
STRAIGHT FOREX © 2005, 2006, 2007
Forex Pivot Points: Mapping Your Time Frame
It is useful to have a map and be able to see where the price is relative to previous market action. This way we can see how is the sentiment of traders and investors at any given moment, it also gives us a general idea of where the market is heading during the day. This information can help us decide which way to trade.
Pivot points, a technique developed by floor traders, help us see where the price is relative to previous market action.
As a definition, a pivot point is a turning point or condition. The same applies to the Forex market, the pivot point is a level in which the sentiment of the market changes from “bull” to “bear” or vice versa. If the market breaks this level up, then the sentiment is said to be a bull market and it is likely to continue its way up, on the other hand, if the market breaks this level down, then the sentiment is bear, and it is expected to continue its way down. Also at this level, the market is expected to have some kind of support/resistance, and if price can't break the pivot point, a possible bounce from it is plausible.
Pivot points work best on highly liquid markets, like the spot currency market, but they can also be used in other markets as well.
Forex Pivot Points
In a few words, pivot point is a level in which the sentiment of traders and investors changes from bull to bear or vice versa.
Why PP work?
They work simply because many individual traders and investors use and trust them, as well as bank and institutional traders. It is known to every trader that the pivot point is an important measure of strength and weakness of any market.
Calculating pivot points
There are several ways to arrive to the Pivot point. The method we found to have the most accurate results is calculated by taking the average of the high, low and close of a previous period (or session).
Pivot point (PP) = (High + Low + Close) / 3
Take for instance the following EUR/USD information from the previous session:
Open: 1.2386
High: 1.2474
Low: 1.2376
Close: 1.2458
The PP would be,
PP = (1.2474 + 1.2376 + 1.2458) / 3 = 1.2439
What does this number tell us?
It simply tells us that if the market is trading above 1.2439, Bulls are winning the battle pushing the prices higher. And if the market is trading below this 1.2439 the bears are winning the battle pulling prices lower. On both cases this condition is likely to sustain until the next session.
Since the Forex market is a 24hr market (no close or open from day to day) there is a eternal battle on deciding at white time we should take the open, close, high and low from each session. From our point of view, the times that produce more accurate predictions is taking the open at 00:00 GMT and the close at 23:59 GMT .
Besides the calculation of the PP, there are other support and resistance levels that are calculated taking the PP as a reference.
Support 1 (S1) = (PP * 2) – H
Resistance 1 (R1) = (PP * 2) - L
Support 2 (S2) = PP – (R1 – S1)
Resistance 2 (R2) = PP + (R1 – S1)
Where , H is the High of the previous period and L is the low of the previous period
Continuing with the example above, PP = 1.2439
S1 = (1.2439 * 2) - 1.2474 = 1.2404
R1 = (1.2439 * 2) – 1.2376 = 1.2502
R2 = 1.2439 + (1.2636 – 1.2537) = 1.2537
S2 = 1.2439 – (1.2636 – 1.2537) = 1.2537
These levels are supposed to mark support and resistance levels for the current session.
On the example above, the PP was calculated using information of the previous session (previous day.) This way we could see possible intraday resistance and support levels. But it can also be calculated using the previous weekly or monthly data to determine such levels. By doing so we are able to see the sentiment over longer periods of time. Also we can see possible levels that might offer support and resistance throughout the week or month. Calculating the Pivot point in a weekly or monthly basis is mostly used by long term traders, but it can also be used by short time traders, it gives us a good idea about the longer term trend.
S1, S2, R1 AND R2...? An Objective Alternative
As already stated, the pivot point zone is a well-known technique and it works simply because many traders and investors use and trust it. But what about the other support and resistance zones (S1, S2, R1 and R2,) to forecast a support or resistance level with some mathematical formula is somehow subjective. It is hard to rely on them blindly just because the formula popped out that level. For this reason, we have created an alternative way to map our time frame, simpler but more objective and effective.
We calculate the pivot point as showed before. But our support and resistance levels are drawn in a different way. We take the previous session high and low, and draw those levels on today's chart. The same is done with the session before the previous session. So, we will have our PP and four more important levels drawn in our chart.
LOPS1, low of the previous session.
HOPS1, high of the previous session.
LOPS2, low of the session before the previous session.
HOPS2, high of the session before the previous session.
PP, pivot point.
These levels will tell us the strength of the market at any given moment. If the market is trading above the PP, then the market is considered in a possible uptrend. If the market is trading above HOPS1 or HOPS2, then the market is in an uptrend, and we only take long positions. If the market is trading below the PP then the market is considered in a possible downtrend. If the market is trading below LOPS1 or LOPS2, then the market is in a downtrend, and we should only consider short trades.
The psychology behind this approach is simple. We know that for some reason the market stopped there from going higher/lower the previous session, or the session before that. We don't know the reason, and we don't need to know it. We only know the fact: the market reversed at that level. We also know that traders and investors have memories, they do remember that the price stopped there before, and the odds are that the market reverses from there again (maybe because the same reason, and maybe not) or at least find some support or resistance at these levels.
What is important about his approach is that support and resistance levels are measured objectively; they aren't just a level derived from a mathematical formula, the price reversed there before so these levels have a higher probability of being effective.
Our mapping method works on both market conditions, when trending and on sideways conditions. In a trending market, it helps us determine the strength of the trend and trade off important levels. On sideways markets it shows us possible reversal levels.
How we use our mapping method?
We use the mapping method in three different ways: as a trend identification (measure of the strength of the trend), a trading system using important levels with price behavior as a trading signal and to set the risk reward ratio of any given trade based on where the is the market relative to the previous session.
STRAIGHT FOREX © 2005, 2006, 2007
Pivot points, a technique developed by floor traders, help us see where the price is relative to previous market action.
As a definition, a pivot point is a turning point or condition. The same applies to the Forex market, the pivot point is a level in which the sentiment of the market changes from “bull” to “bear” or vice versa. If the market breaks this level up, then the sentiment is said to be a bull market and it is likely to continue its way up, on the other hand, if the market breaks this level down, then the sentiment is bear, and it is expected to continue its way down. Also at this level, the market is expected to have some kind of support/resistance, and if price can't break the pivot point, a possible bounce from it is plausible.
Pivot points work best on highly liquid markets, like the spot currency market, but they can also be used in other markets as well.
Forex Pivot Points
In a few words, pivot point is a level in which the sentiment of traders and investors changes from bull to bear or vice versa.
Why PP work?
They work simply because many individual traders and investors use and trust them, as well as bank and institutional traders. It is known to every trader that the pivot point is an important measure of strength and weakness of any market.
Calculating pivot points
There are several ways to arrive to the Pivot point. The method we found to have the most accurate results is calculated by taking the average of the high, low and close of a previous period (or session).
Pivot point (PP) = (High + Low + Close) / 3
Take for instance the following EUR/USD information from the previous session:
Open: 1.2386
High: 1.2474
Low: 1.2376
Close: 1.2458
The PP would be,
PP = (1.2474 + 1.2376 + 1.2458) / 3 = 1.2439
What does this number tell us?
It simply tells us that if the market is trading above 1.2439, Bulls are winning the battle pushing the prices higher. And if the market is trading below this 1.2439 the bears are winning the battle pulling prices lower. On both cases this condition is likely to sustain until the next session.
Since the Forex market is a 24hr market (no close or open from day to day) there is a eternal battle on deciding at white time we should take the open, close, high and low from each session. From our point of view, the times that produce more accurate predictions is taking the open at 00:00 GMT and the close at 23:59 GMT .
Besides the calculation of the PP, there are other support and resistance levels that are calculated taking the PP as a reference.
Support 1 (S1) = (PP * 2) – H
Resistance 1 (R1) = (PP * 2) - L
Support 2 (S2) = PP – (R1 – S1)
Resistance 2 (R2) = PP + (R1 – S1)
Where , H is the High of the previous period and L is the low of the previous period
Continuing with the example above, PP = 1.2439
S1 = (1.2439 * 2) - 1.2474 = 1.2404
R1 = (1.2439 * 2) – 1.2376 = 1.2502
R2 = 1.2439 + (1.2636 – 1.2537) = 1.2537
S2 = 1.2439 – (1.2636 – 1.2537) = 1.2537
These levels are supposed to mark support and resistance levels for the current session.
On the example above, the PP was calculated using information of the previous session (previous day.) This way we could see possible intraday resistance and support levels. But it can also be calculated using the previous weekly or monthly data to determine such levels. By doing so we are able to see the sentiment over longer periods of time. Also we can see possible levels that might offer support and resistance throughout the week or month. Calculating the Pivot point in a weekly or monthly basis is mostly used by long term traders, but it can also be used by short time traders, it gives us a good idea about the longer term trend.
S1, S2, R1 AND R2...? An Objective Alternative
As already stated, the pivot point zone is a well-known technique and it works simply because many traders and investors use and trust it. But what about the other support and resistance zones (S1, S2, R1 and R2,) to forecast a support or resistance level with some mathematical formula is somehow subjective. It is hard to rely on them blindly just because the formula popped out that level. For this reason, we have created an alternative way to map our time frame, simpler but more objective and effective.
We calculate the pivot point as showed before. But our support and resistance levels are drawn in a different way. We take the previous session high and low, and draw those levels on today's chart. The same is done with the session before the previous session. So, we will have our PP and four more important levels drawn in our chart.
LOPS1, low of the previous session.
HOPS1, high of the previous session.
LOPS2, low of the session before the previous session.
HOPS2, high of the session before the previous session.
PP, pivot point.
These levels will tell us the strength of the market at any given moment. If the market is trading above the PP, then the market is considered in a possible uptrend. If the market is trading above HOPS1 or HOPS2, then the market is in an uptrend, and we only take long positions. If the market is trading below the PP then the market is considered in a possible downtrend. If the market is trading below LOPS1 or LOPS2, then the market is in a downtrend, and we should only consider short trades.
The psychology behind this approach is simple. We know that for some reason the market stopped there from going higher/lower the previous session, or the session before that. We don't know the reason, and we don't need to know it. We only know the fact: the market reversed at that level. We also know that traders and investors have memories, they do remember that the price stopped there before, and the odds are that the market reverses from there again (maybe because the same reason, and maybe not) or at least find some support or resistance at these levels.
What is important about his approach is that support and resistance levels are measured objectively; they aren't just a level derived from a mathematical formula, the price reversed there before so these levels have a higher probability of being effective.
Our mapping method works on both market conditions, when trending and on sideways conditions. In a trending market, it helps us determine the strength of the trend and trade off important levels. On sideways markets it shows us possible reversal levels.
How we use our mapping method?
We use the mapping method in three different ways: as a trend identification (measure of the strength of the trend), a trading system using important levels with price behavior as a trading signal and to set the risk reward ratio of any given trade based on where the is the market relative to the previous session.
STRAIGHT FOREX © 2005, 2006, 2007
Forex Strategy : Swing Trading with Elliott Wave
When evaluating the forex market for swing trade opportunities the focus is placed on predicting directional changes or continuations for a given currency pair. For this we rely on technical analysis.
In technical analysis, just as in fundamental analysis, there are lagging indicators and leading indicators. One of the most reliable tools used to predict forex market swings is Elliott Wave analysis. Elliott Wave analysis can be used to identify trends and countertrends, trend continuation or exhaustion and to evaluate the potential price targets of a trend.
You can apply Elliott Wave analysis to both long and short position swing trade set ups for your currency pairs.
Elliott Wave theory is named after Ralph Nelson Elliott, who concluded that the markets moved in a repetitive pattern of waves. He attributed this action to the mass psychology of the market.
Elliott concluded that the market¡¯s movement was a direct result of the mass psychology of the time and that the stock market is a fractal. A fractal is an object that is similar in shape, but at different scales. A great example of a fractal in nature is a stalk of broccoli. The stalk and the individual branches look exactly the same; just the branches are smaller in scale.
Fractals just happen to form in accordance with Fibonacci ratios. Is this a coincidence?
Elliott attributes this mass psychological move to the human trait of herding. Even though Elliott¡¯s theories were based on stock market price movements, it has been applied to evaluating Presidential approval ratings and fashion trends changes as well.
The conclusion, the market price actions are not the cause of economic growth or slow down, but the reflection of the mass psychology of investors. If the mood of the investing public is upbeat then a bull market ensues. This is counter to what most individual perceive, that because there is a bull market the mood of the investing public is upbeat.
Elliott Wave patterns follow a sequence that the markets move up in a series of 3 waves and down in a series of 2 waves. This 3 wave impulse and 2 wave corrective sequence form the foundation of the 5 Wave impulse pattern (the opposite is true in a downtrend).
The Elliott Wave Counts are as follows;
Wave 1 - Short Covering
Wave 2 - Pullback from Short Covering
Wave 3 - Major Rally Phase
Wave 4 - Institution Pause in the Rally
Wave 5 - Retail Buying
Wave 1 is usually the weakest of the impulse waves. It is a brief rally based on short covering of the bears from a previous move down. When Wave 1 is complete, the currency pair sells off, creating Wave 2.
Wave 2 ends when the market fails to make new lows. You often see dominant reversals patterns form at the end of this wave signaling the being of the rally phase or Wave 3.
Wave 3 is the longest and strongest of the impulse waves. This signals strong currency buying or selling in the direction of the trend. This trend usually starts of slowly, but tends to accelerate as it breaks to new highs above the top of Wave 1.
Like any trend, especially a strong trend a correction will occur. Traders will begin to take profits and the currency pair will retrace. This signals the beginning of Wave 4.
Again the currency pair will rally ushering in the Wave 5 rally. Wave 5 is typically supported by the retail traders and not institutional buyers (the herd) and tends to lack the momentum generated in the Wave 3 rally. This creates divergence that can be easily measured on any technical oscillator. After the currency pair breaks to new highs above the previous Wave 3 high, the rally loses steam and changes trend.
This trend change can result in either a new 5 Wave impulse pattern or a corrective in nature.
Now that we know what the Elliott Wave analysis is, how would a currency trade using this analysis look like, just as an example?
Look to Wave 5 as the most reliably tradable impulse wave. The trade sets up as follows. Look for the Elliott Oscillator to pull back between 90% and 140% of the Wave 3 high on a daily chart. This pullback should correspond to a 38%-62% Fibonacci retracement from the Wave 2 extension. This signal is the strongest when the Fibonacci retracement is between 38% - 50%.
Like any technical analysis tool you never want to employ an indicator as a stand alone analysis tool. A trigger and a confirming indicator are required as well.
Look for a trigger in candle patterns, such as Harami, Tweezers or Harami cross. There are a variety of software packages on the market that perform Elliott Wave counts and have other entry signal indicators as well.
Draw a regression channel on the Wave 4 retracement and look for a break above or below the channel as confirmation to enter the trade.
Place stops at the high of the Wave 1 advance, just below the 38% Fibonacci retracement level or where your individual trading plan dictates. Trail your stops once the currency pair has advanced past the Wave 3 high. Look for reversal candle patterns like doji, hammers, shooting stars or hanging mans for signals that the wave is about to end or stall. A typical price target is 127% retracement of the Wave 4 low.
This is just a glimpse of how Elliott Wave analysis can be deployed to enhance your forex swing trade evaluations. Look more into the Elliott Wave theory and other strategies as tools for increasing your forex swing trade opportunities.
About the Author
Todd Judkins specializes in teaching real people how to trade the Forex market for long term success by focusing on strategic, mind and money skills. He is a currency trader, educator and success coach to traders. Are you now ready to take action? To begin training with Todd for immediate, online Forex trading education visit: http://www.forexjourney.com and sign up for his FREE Forex Webinar.
In technical analysis, just as in fundamental analysis, there are lagging indicators and leading indicators. One of the most reliable tools used to predict forex market swings is Elliott Wave analysis. Elliott Wave analysis can be used to identify trends and countertrends, trend continuation or exhaustion and to evaluate the potential price targets of a trend.
You can apply Elliott Wave analysis to both long and short position swing trade set ups for your currency pairs.
Elliott Wave theory is named after Ralph Nelson Elliott, who concluded that the markets moved in a repetitive pattern of waves. He attributed this action to the mass psychology of the market.
Elliott concluded that the market¡¯s movement was a direct result of the mass psychology of the time and that the stock market is a fractal. A fractal is an object that is similar in shape, but at different scales. A great example of a fractal in nature is a stalk of broccoli. The stalk and the individual branches look exactly the same; just the branches are smaller in scale.
Fractals just happen to form in accordance with Fibonacci ratios. Is this a coincidence?
Elliott attributes this mass psychological move to the human trait of herding. Even though Elliott¡¯s theories were based on stock market price movements, it has been applied to evaluating Presidential approval ratings and fashion trends changes as well.
The conclusion, the market price actions are not the cause of economic growth or slow down, but the reflection of the mass psychology of investors. If the mood of the investing public is upbeat then a bull market ensues. This is counter to what most individual perceive, that because there is a bull market the mood of the investing public is upbeat.
Elliott Wave patterns follow a sequence that the markets move up in a series of 3 waves and down in a series of 2 waves. This 3 wave impulse and 2 wave corrective sequence form the foundation of the 5 Wave impulse pattern (the opposite is true in a downtrend).
The Elliott Wave Counts are as follows;
Wave 1 - Short Covering
Wave 2 - Pullback from Short Covering
Wave 3 - Major Rally Phase
Wave 4 - Institution Pause in the Rally
Wave 5 - Retail Buying
Wave 1 is usually the weakest of the impulse waves. It is a brief rally based on short covering of the bears from a previous move down. When Wave 1 is complete, the currency pair sells off, creating Wave 2.
Wave 2 ends when the market fails to make new lows. You often see dominant reversals patterns form at the end of this wave signaling the being of the rally phase or Wave 3.
Wave 3 is the longest and strongest of the impulse waves. This signals strong currency buying or selling in the direction of the trend. This trend usually starts of slowly, but tends to accelerate as it breaks to new highs above the top of Wave 1.
Like any trend, especially a strong trend a correction will occur. Traders will begin to take profits and the currency pair will retrace. This signals the beginning of Wave 4.
Again the currency pair will rally ushering in the Wave 5 rally. Wave 5 is typically supported by the retail traders and not institutional buyers (the herd) and tends to lack the momentum generated in the Wave 3 rally. This creates divergence that can be easily measured on any technical oscillator. After the currency pair breaks to new highs above the previous Wave 3 high, the rally loses steam and changes trend.
This trend change can result in either a new 5 Wave impulse pattern or a corrective in nature.
Now that we know what the Elliott Wave analysis is, how would a currency trade using this analysis look like, just as an example?
Look to Wave 5 as the most reliably tradable impulse wave. The trade sets up as follows. Look for the Elliott Oscillator to pull back between 90% and 140% of the Wave 3 high on a daily chart. This pullback should correspond to a 38%-62% Fibonacci retracement from the Wave 2 extension. This signal is the strongest when the Fibonacci retracement is between 38% - 50%.
Like any technical analysis tool you never want to employ an indicator as a stand alone analysis tool. A trigger and a confirming indicator are required as well.
Look for a trigger in candle patterns, such as Harami, Tweezers or Harami cross. There are a variety of software packages on the market that perform Elliott Wave counts and have other entry signal indicators as well.
Draw a regression channel on the Wave 4 retracement and look for a break above or below the channel as confirmation to enter the trade.
Place stops at the high of the Wave 1 advance, just below the 38% Fibonacci retracement level or where your individual trading plan dictates. Trail your stops once the currency pair has advanced past the Wave 3 high. Look for reversal candle patterns like doji, hammers, shooting stars or hanging mans for signals that the wave is about to end or stall. A typical price target is 127% retracement of the Wave 4 low.
This is just a glimpse of how Elliott Wave analysis can be deployed to enhance your forex swing trade evaluations. Look more into the Elliott Wave theory and other strategies as tools for increasing your forex swing trade opportunities.
About the Author
Todd Judkins specializes in teaching real people how to trade the Forex market for long term success by focusing on strategic, mind and money skills. He is a currency trader, educator and success coach to traders. Are you now ready to take action? To begin training with Todd for immediate, online Forex trading education visit: http://www.forexjourney.com and sign up for his FREE Forex Webinar.
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