Research shows that the amount of capital in your trading account can affect your profitability. Traders should look to use an effective leverage of to1 or less. In looking at the trading records of tens of thousands of clients from a major FX broker, as well as talking with even more traders daily via live webinars, Twitter , and email, it appears that traders enter the Forex market with a desire to cap their potential for losses on their risk based capital.
Therefore, many newer traders choose to start trading forex with a small capital base. What we have found out through the analysis of thousands of trading accounts is that traders with larger account balances tend to be profitable on a higher percentage of trades. Since many smaller traders are inexperienced in trading forex, they tend to expose their account to significantly higher levels of effective leverage.
As a result, this increase in leverage can magnify losses in their trading account. Emotionally spent, traders then either give up on forex or choose to compound the issue by continuing to trade in relatively high amounts of effective leverage.
This becomes a vicious cycle that damages the enthusiasm which attracted the trader to forex. No matter how good or bad your strategy is, your decision or non-decision, as the case may be about effective leverage has direct and powerful effects on the outcomes of your trading.
Last year, we published some tests showing the results over time of the same strategy with different leverage. You can read it in the article Forex Trading: Controlling Leverage and Margin. In figure 2, we have modified 2 elements of the chart in figure 1. First, we renamed each column to represent the highest dollar value that qualified for the given column.
The second change made was that we calculated the average trade size of each group and divided it into the maximum possible account balance for that group. In essence, this provided us a conservative and understated effective leverage amount. A larger balance reduces the effective leverage so the red line on the chart is the lowest and most conservative calculation of the chart. If we take the average trade size and divide it by the account equity, the result is the effective leverage used by that group on average.
We recommend trading with effective leverage of 10 to 1 or less. Therefore, keep the effective leverage at conservative levels while using a stop loss on all trades. Here is a simple calculation to help you determine a target trade size based on your account equity.
The precise amount of leverage used is decided entirely by each individual trader. You may decide that you are more comfortable using an even lower effective leverage such as 5 to 1 or 3 to 1. Most professional traders enter into trading opportunities focused on how much capital they stand to lose rather than how much capital they are looking to gain. Nobody knows the future movement of prices so professional traders are confident in their trading approach but conservative in their use of effective leverage.
Their effective leverage is at least 26 times which is significantly higher than the 10 times leverage discussed earlier. If these traders want to trade at no more than a 10 to 1 effective leverage, they would need to make at least one of the adjustments noted below: Increase their trading account equity by depositing more funds to an amount that reduces their effective leverage to less than 10 to 1. Decrease their trade size to a level that reduces their effective leverage to less than 10 to 1.
Use the figure 3 calculations and chart above. Perhaps they want a large enough trade size to make their time invested trading worthwhile. Using a conservative amount of leverage will help slow down the rate of capital losses when a trader goes through a losing streak. Regardless of the reasons, our goal is to use conservative amounts of leverage.
If you know how much risk capital you have available, then use the chart and calculations used in Figure 3 to determine an trade size appropriate to your account size. Increasing your capital base does not mean you will become more profitable. It means that you can stay in a trade longer if it goes against you. Amateur's Reaction to a Losing Trade 8 of The DailyFX Course Instructors have years of experience trading the markets and helping thousands of new traders learn forex.
How to Determine Appropriate Effective Leverage. DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
Click here to dismiss. Figure 1 Since many smaller traders are inexperienced in trading forex, they tend to expose their account to significantly higher levels of effective leverage. Figure 2 In figure 2, we have modified 2 elements of the chart in figure 1. How much effective leverage should I use? Amateur's Reaction to a Losing Trade 8 of 50 Previous: Foundations of Technical Analysis: Classic Chart Patterns, Part I.
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