Total Risk – Margin – Leverage Security

“Total Risk” is the idea of limiting your overall risk to a certain percentage. You are managing your overall risk, and this directly impacts your profitability.

But how do you know what that percentage should be?

If you listen to the mainstream culture in Forex, you will often hear “it depends on your comfort level.” Sorry, but that’s ridiculous. The amount of your total risk is a function of your win/loss ratio. Why? Because your win/loss ratio determines your drawdown potential. Your drawdown potential is the number of trades you can potentially lose in a row when something changes in the market place (something you could not anticipate).

Now that we know that, we can ask this question: when you do lose, how much do you want to lose?

Let’s talk about the numbers. In an 80% area of wins, you are looking at 2-4 losses during a drawdown. In the 70% area, you are looking at 4-6. In a 65% area, you are looking at 8- 12.

To illuminate this a little, if you are winning 80%, for example, and you are a trend trader,

you are probably seeing a market going into a range before you get hit with too many losses. As a break out trader with 80% wins, you are probably experienced enough to see and have defined when a break out is likely to be a false breakout.

In other words, the “changes” impact you less. But keep in mind that the higher your win/loss ratio, the fewer trading opportunities you will get. So remember that “balance” you are working towards.

But “risk to equity” is more like doing math. Fine tuning it comes easily with experience. So let’s imagine you are like many traders, using the “comfort strategy.” You are not actually comfortable, the emotion of greed is causing blinds spots in your risk

assessment.

So you risk 10% per trade. Well, if your win/loss ratio is 72%, are you okay losing 50% of your account very quickly, only to realize that now you must make double the amount to get back to where you were? Think about it. If you have $10,000 and are risking 10% ($1000

per trade at 1:1), without being picky about the actual numbers, in five losses, you are now at $5000. But now when you risk 10%, you are only making $500 instead of $1000. Not only did you lose 50% of your account, now you must go twice the distance (not the

same distance) to gain your money back. It’s like losing twice. But if this happens to

you, know that this road has been traveled by many traders that came before you. You simply needed to learn the hard way. That’s all. Some lessons require a painful

experience in order to sink in. If it happens, it was a mistake in your method of operation. Learn from it, correct it, and leave it in the past.

There is some subjectivity with regards to risk to equity, to be sure. But not THAT much. I have found it is very good to give the guideline of a maximum risk to equity of 2.5%. So in level 3, this is what I suggest you do.

To be very clear, this means that at any moment in time, you are at no more than 2.5% risk. So if you have $1000 in your account, the most you can risk AT ANY TIME is $25. I should also point out that you should be consistent. If, for example you risk 1% in one trade, and 2.5% in another trade, this could seriously throw off your bottom line number. Perhaps, for example, you lost 2.5% on that trade, but gained only 1% in a trade that hit your target. I say “maximum,” because often you will be “close” to 2.5%, but do not want to exceed it. Part of the reason for this is that there are inefficiencies, depending on your amount of equity. I’ll discuss that in Level 4, where you are dealing with real money, and are less likely to be trading such large sums of pretend money.

There are some advanced strategies that you can learn and employ later. For example there was a trader I learned from that had been trading Forex for 33 years (in 2005) had a technique of increasing the risk with each loss.

So he might have begun at 1%. If he lost, he increased to 1.5%. If he lost again, he increased to 2%. It could be argued that this is a way of helping to manage the drawdown factor. Personally, I view this as managing personal psychology more than I see it

managing risk.

I like it simple. My total risk is always close to the same percentage. My rewards can vary depending on what the market presents me. But it is rare that I will hold a position longer. I’d rather take the gain and look for another trade, than wait for more and potentially lose what I have. But that’s me.

As I said, there are very advanced strategies that are beyond the scope and goals of this program. But you will find them in time when you have interest and experience. When you do, hopefully I will have given you the tools to properly evaluate the functions at work so you can decide if an idea is really good for you.

At this point, set your maximum risk to equity to 2.5%. Once the entry and stop price values are entered, the calculator will tell you how many contracts you can trade. You can find a place to download the trade calculator at www.forexartofwar.com if you are not a member our community.

Contract Size

First of all, as a reminder, (for all practical purposes) a Contract and a Lot are the same thing. I use the word contract. You are trading a contract for the money, not the actual money itself.

The most common are $1k contracts, 10K contracts, and $100k contracts.

If the USD is in the quoted position, as with the EUR/USD and the GBP/USD, then the value of the PIP is easy to determine. A single 1K contract, moving 1 PIP has a value of ten cents .10). $10k contract is $1 per PIP. $100K is $10 per PIPs.

So if you bought with 5 $10k contracts, each PIP of movement up or down the chart will be worth $5.

As I wrote in an earlier section, if the USD is not in the quoted position, you must go to your broker to find out what the PIP value is, or you can’t actually manage the risk. Another reason to stick with the four pairs for now that I recommended.

Margin and Leverage

We’ve heard these words a lot since the crash of 2008. If you just listen to the mainstream information, you would think 1. You can make more money with more leverage. 2. You are more at risk with more leverage. Not exactly.

What is Margin? Margin is the amount of money you must put on hold to cover a position. We also call this “used margin.” It is subtracted from your balance and “set aside.” What is left is called “useable margin,” which suggests that it was all margin in the first place.

So just imagine you have $5000 in the account, and you must put $1000 on margin. That means that you have $4000 of useable margin. If you happen to use that up on a day you totally lose your mind, you get what is called a “margin call.” This triggers your position(s) to close and your $1000 (on margin) is returned to you.

But margin calls can happen without such catastrophic implications. After the crash of 2008, we needed to get very precise in very uncertain market conditions. So there were times when we could see a potential move of only 7 or 8 PIPs targeting .75:1 with a 2.5% max risk. What we found out was that this was about the limit of our useable margin. Keep in mind that I’m referring to the 50:1 leverage we are limited to in the US.

Here’s how that works: The

smaller your stop loss, the greater the number of contracts you can trade. As

you increase the number of contracts, your useable margin decreases. At a point in time, you don’t have enough

useable margin to execute that trade at that percentage of risk. At the time, this was the GU, and the limit was 8 PIPs. I say “at the time” because these numbers fluctuate. Above is a chart at FXCM showing you what the requirements are. I highlighted the pairs I am suggesting. This is on a $1k contract. So PIPs are valued at ten cents. You increase by 10X to get to 10K or 100k contracts. Notice how the margin requirements are different. To give a more specific example, let’s say that you had $5000 in your account, and you set your maximum risk to 2.5%. That means you can risk $125.

How much margin will be required will be determined by the number of contracts you trade, which will be determined by the size of your stop loss.

So, for example, if your stop loss is 25 PIPs, you could trade five 10k contracts. Because each 10k contract has a PIP value of $1. So five 10K contracts would have a PIP

movement value of $5 (per PIP on your chart). So a 25 PIP stop would result in a $125 loss. If you were trading the GBP/USD, the margin requirement would be $340 X 5, which

is $1700. That leaves you $3300 in useable margin. Now cut the stop loss in half to 12.5 PIPs. This now doubles your margin to $3400, leaving you only $1600 in useable margin. As you can see, if you tried to cut that stop loss in half yet again, this would double your margin requirements to $7200, and I remind you that you only have $5000 in your account. If you lower your max risk (to say 1%) this would provide more useable margin, and allow you to get even closer (though getting into ranges this small then expose you to the “noise” factor). Isn’t it interesting to find these “borders” of our trading world?

One of my points was that you could be using a small stop, running right on the edge (maximum useable margin), get a margin call, and really not lose that much.

Now let’s address some questions. Is leverage good? Leverage is a tool. Did the

government (in the US) do us a favor by lowering our leverage from 400:1 to 50:1. Did they save us?

Not really. If you were trading with FXCM (who almost went bankrupt when the Swiss bankers pulled their stunt), and they went bankrupt, you would have lost your entire

account. I know people will tell you otherwise. They will talk about “segregated accounts,” but trust me, you will LOSE all of your money if the broker goes bankrupt. There are some possible exceptions. But the best bet is to choose your broker wisely. This can only be done by taking a look at the value and the management of the brokerage.

So there is that risk, though it might be small with a major. Has it happened? Yes, in 2005, Refco (at the time the largest retail Forex broker) did go belly up. And yes, me and my friends lost around $300,000 in total money.

Here’s the point. Back when we had 400:1 leverage, I could keep 75% of my money in an insured bank, 25% in the brokerage account, but trade the 100%. I had enough margin with only 25% on deposit. When you lower the leverage to 50:1, you lose that ability.

What is leverage? In this context it is simply borrowing money. In our example above, we were trading $50,000 with only $1700 on margin (25 PIP stop). That means we borrowed $48,300. Do they charge interest? Yes, but the daily rate is not very high. And on that subject, note that on Wednesdays at 2PM ET (until 2:15), if you are in a trade at that time, you pay triple the interest. In essence, you are paying for Saturday and Sunday on

there is movement just before that time?). Also of interest, if you are trading with Interactive Brokers, for example, during that period (of any day), you will see your trading platform just go blank. Those are unfamiliar with this fact probably skipped a heartbeat if they were in a trade the first time they saw this.

This is not usually the case with dealing desks like Oanda or FXCM.

Do we need leverage? For Forex trading, we sure do. If there were no leverage at all, there would be little or no speculation at all. It simply would not be attractive. Think about it. Let’s say you had $10,000 and put it all on the EUR/USD. Let’s say that price moved up 20 PIPs in profit for your trade. You just made $20 for your day’s work. See what I mean? Even if you take it up to $100,000, now you have made $200 for your work.

Does higher leverage put me more at risk? No, not really. Not for a skilled Forex trader anyway. If you are limiting your risk to 2.5%, using that 25 PIP stop, for example, you don’t even need the 50:1. You used $1700 of your $5000, and still have $3400. So if it dropped to 25:1, you would still be okay. The threshold at 2.5% is around 20:1. And then you are still okay if your method enables you to increase your stop loss size. But the point is that if I have $5000 in my account, my total risk at 2.5% is $125. That’s true whether I have 400:1 or 25:1 leverage. So no, leverage does not increase the risk. Did they save the

irresponsible people? I think those guys are going to lose their money no matter what anyone does, but yes, they probably diverted them to some other latest greatest scheme to make fast money.

I think what the government was really doing was trying to shut down hedging strategies. There were thousands of people following complex hedging strategies without really

knowing what they were doing. There came a time when almost all got a margin call when the market moved well outside of the normal parameters.

This is what happened in the movie Margin Call with Kevin Spacey. It’s similar to what happened to the banks, which was the last step towards the financial cliff. If you are over

exposed to risk, eventually your luck will run out.

For the skilled Forex trader, all of this is just drama in the background.

I know I let a tiger loose in the background. The catastrophic risk of a broker going bankrupt is real. That’s not the only risk you do not control. There were traders who lost their entire

accounts when the Swiss made the decision to unpeg from the Euro last fall. In fact, legally

traders were responsible for money lost that they didn’t have on deposit. Companies

like Oanda covered those losses (the amounts which exceeded that which was on deposit). Did our team lose anything? No. Years earlier when the Swiss made the decision to

manipulate the currency, I took it off of my chart and suggested everyone else do the same. I don’t like betting on a fight that is fixed. Did we miss out on making money trading the Swiss Franc? I suppose. But that’s part of making decisions. Where you can avoid

catastrophic risk, you must.

For this reason I don’t trade the Yen either. The Bank of Japan has a long history of manipulating their currency, and to their advantage, I might add. So I’m saying that there are things you can do to minimize these risks, and we take those steps on our team. In the big picture, the chances are small that a major broker will suffer complete failure in the US. But it is possible.

I feel pretty good about the majors that are left, which survived the incredible movement following the Swiss bank decision. They survived the crash of 2008 as well. I think in the future we will begin seeing insured accounts with dealers. This is already the case in the UK. According to Interactive Brokers, funds are segregated and much more secure. They are the preferred choice of professional fund traders, as far as I know. Perhaps on this issue, you can take some comfort in knowing that there is less risk when you are ready to trade larger amounts.