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 successful trading.
This testimonial arrived in my inbox from one of my existing clients and it supports my belief that we are on the right route.
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:
- 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.
- 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 (open positions).
- 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”.
“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”.
Kind regards
Dirk D. du Toit
Dirk D. du Toit
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