Margins....leverage etc

Beginner Questions
1

I was just wondering if its possible to trade without margin? If I open a $100,000 account for example then to trade one single lot the value is $100,000 anyway so wouldn’t need any leverage right? My understanding (obviously I’m a seriously new newbie) is that with a $10,000 account for example, to trade one single lot that is $100,000 with leverage.

The reason I ask is that if I don’t use leverage then I can’t possibly get a margin call which means I can leave positions open longer if needed.

Thanks and apologies for the painful newbie question.

2

Your first paragraph is spot on.

Yes, you can trade without leverage. With a $100,000 account, you could trade one standard lot (100,000 units of currency); with a $10,000 account you could trade one mini-lot (10,000 units of currency); with a $1,000 account, you could trade one micro-lot (1,000 units of currency); and with a $100 account, you could trade one nano-lot (100 units of currency) — all without using leverage.

Think about what you just said. It really means this: If I don’t use leverage, then I can blow my entire account on one trade, without being bothered by a margin-call from my broker.

Why would you want to do such a thing?

The first rule of forex trading is: CONTROL RISK. That means: limit losses.

Suppose you have an account with a U.S. broker. Your maximum allowable leverage is 50:1 (dictated by the almighty CFTC). Now, suppose that you choose to use 25:1 leverage on a particular trade. Finally, suppose that you lose HALF of your account on this trade, triggering a margin-call which automatically closes your position. The problem is NOT that you got a margin-call. The problem is that you lost HALF your account. You should NEVER expose yourself to losses of that magnitude.

Learn to do the math regarding leverage, margin, position size, and risk (as a percentage of your account balance).

Most traders will tell you to limit your risk on every trade to 2%, or less, of your account balance. If you do that, your position size WILL be appropriate, relative to your account balance. And the amount of leverage you are using WILL NOT be a matter of concern to you — and you will NEVER face a margin-call.

3

The reason I asked is because the way I’ve been trading (all of a week on demo) I’ve found if I do get it wrong and it goes up when I wanted it to go down or vice versa then if I just wait then sooner or later it goes up to what I thought it was going to do…or at least back to break even point. Does a demo account work in the same way as a real one in terms of margin calls? Since I’ve been using leverage quite a bit but never got a margin call so far.

I’ve took a $10000 account to $17000 in a week using this method, with no negative trades. I’m doing some form of scalping method. I’m sure I must be doing something wrong or otherwise I can’t explain why this stupid method seems to work so well.

4

Yes, demo accounts work basically the same as live trading accounts, with this exception: [B]slippage[/B] sometime occurs in live accounts, because trades can be opened or closed ONLY if there is actual liquidity instantly available in the market to complete the trade. In the case of demo trades, they are fictitious — they do not connect to bank liquidity, so they never suffer slippage.

As for your trading method, I would compare it to a game of Russian Roulette — you know, a six-shooter with 5 empty chambers, and a bullet in one chamber. When that bullet shows up with your name on it, you blow your brains out.

With your trading method, “when that bullet shows up”, you won’t blow your brains out; but, you may find yourself down 500 pips, or 700 pips, or 1,000 pips, with slim hopes for a reversal. Then, what will you do? Keep playing this same game?

I knew a guy once who had a system similar to yours. His method worked like this: On every trade, he used a 10 pip T/P, and a 100 pip S/L. He was absolutely convinced that the market would never go 100 pips against him, before it had gone at least 10 pips in his direction. He was trading real money. His system worked great. Until it didn’t.

There’s a saying which applies to all markets: The market can remain irrational longer than you can remain solvent.

With your trading method, you are betting (as in gambling) that you can remain solvent longer than the market can remain irrational.

Good luck with that.

5

Ok that makes sense. One part I still don’t get though is, why only wager a very small position every time? Sure, your losses will be minimised but also your wins will be limited too so isn’t it a bit ‘swings and roundabouts’ really? I mean, as long as you’re not betting such ridiculous amounts that your whole account could go in one trade, surely if you’re winning more trades than you’re losing you’d be better off with slightly bigger positions each time than smaller? Whether you place a half lot or a full lot each time, for win win lose lose win lose aren’t you in the same position either way?

This is on the assumption that you have had enough education and training and have been consistently profiting with a demo account for a long while. Maybe small positions right at the beginning of using a live account is sensible but sooner or later, surely bigger positions make more sense since theoretically you’re winning more trades than you lose?

6

Actually, there is a sound mathematical basis for what you are suggesting. The theory is called the Kelly Criterion, and it basically says that, given two specific parameters, there is an optimum trade size for growing your account as quickly as possible.

The Kelly Criterion Formula is:

Kelly % = W - [(1 - W) / R]

where W = your overall trading success rate (that is, the probability that your next trade will be a winner), and

R = your overall win/loss ratio (calculated as your average winning trade divided by your average losing trade)

The term Kelly % denotes the percentage of your account that you should risk on each trade. These percentages typically represent trade sizes which are MANY TIMES the size of the trades most traders are comfortable with.

The increase in risk associated with this strategy is significant. It can be shown mathematically that for ANY set of parameters W and R used to calculate the Kelly %, the following drawdown probabilities apply, over the long term:

there is a 75% probability of a 25% drawdown

there is a 50% probability of a 50% drawdown

there is a 10% probability of a 90% drawdown

there is a 1% probability of a 99% drawdown

Not many traders would adopt a trading plan in which 25% drawdowns are very likely, 50% drawdowns are a coin-toss, and there’s a one-in-ten chance of a devastating 90% loss of trading capital.

Nevertheless, the Kelly Criterion creates endless fascination for traders looking to “push the envelope”.

Here are links to a couple of articles on the Kelly Criterion:

Kelly criterion - Wikipedia, the free encyclopedia

Money Management Using the Kelly Criterion

Having said all that, my advice to you as a brand-new newbie, is this: Ignore the Kelly Criterion, and the Martingale System, and all the other get-rich-quick trading methods you might hear about, until you have learned how to trade in a conservative and consistently profitable manner.

Conservative means: Practicing what experienced traders call sound money management.

Consistently profitable means: Earning 1%, or 2%, or 5% per week, every week, week after week, for a year.

After you have demonstrated that you have the knowledge, the skill, the drive, and the discipline to accomplish that — then, decide whether the Kelly Criterion is worth another look.

7

Wow you sure know how to answer newbie questions! Thanks so much for your help. One advantage I have with my personality is that I can be very patient. I know I’m just beginning and will analyse things to the very end before I risk anything.

8

Hey Clint,

I was reading your post and it made me wonder, assuming a 10k account, with say… 20:1 leverage, how does the 2% risk come into play?

Account Balance: $10,000
Risk (2% of total): $200

So if I opened a position, I’d make sure that my stop loss in pips would be equivalent to $200 should the trade move against me.

I’m currently trading a demo with 20:1 leverage, and can’t really figure out if there’s anything different going on behind the scenes compared to say… a 10:1 or 50:1.

Where does the leverage change things? The number of units purchased are still input by the user. Does having leverage just mean that you can have more open positions?

for example a 10:1 $10,000 account could have open positions totaling $100,000 at max?
and a 20:1 $10,000 account could have open positions totaling $200,000 at max?

Thanks!

9

Not Clint here, so forgive me…

BUT, in answer to your questions, yes, $200 is 2% of your $10,000 account.

Leverage comes into play with how you manage that 2%.

If you used a standard $100k lot size, your $200, depending on currency would be 15 to 25 pips or so before your 2% was toast. You would use $2k in margin, and be leveraged at 10:1

If you traded one mini lot instead, your leverage would decrease, and your $10,000 lot size would afford you 200 pips before your 2% was hit. You would use $200 in margin, and you would be leveraged at 1:1

If you traded one micro lot ($1,000 lot size) you would be using $20 in margin, and be reverse leveraged at 1:10, and your 2% would give you roughly 2,000 pips before it was in danger.

Personally I use the reverse leverage advantage. I usually have a lot of trades either open, or pending, it just lets me sleep stress free, and leaving one open over the weekend is never a concern.

10

Thanks Master Tang, i just mentioned clint since I was quoting him.

So I think I kinda understand what you posted, but I don’t really know how to apply it to my account.

I’ve been using the tool on babypips to calculate my position size:
Position Size Calculator: Free Online Forex Position Sizing Calculator

I’ll give you an example of one of my practice trades, maybe you can help me understand this a bit better (I used the tool to calculate my position)

===============================
Account Equity: $4865.68
Leverage: 20:1

Pair: AUDNZD (long)
Entry: 1.27629
Stop: 1.25536 (465 pip stop)
Units: 5000 (In MT4, size: 0.05)

Current price: 1.30195
Pips gained: 256.6
Profit ($): 105.27

All of the positioning is based on the results I got from the BabyPips tool after inputting the appropriate price and Pip stop.

Now my question is: If my leverage was 10:1, what would change? If it was 50:1, what would change?

I know I’m asking for a lot, and I really appreciate all your help.

Thank you so much!

11

Wow, the other guys pretty much hit the nail on the head here. That Kelly Criterion Formula looks interesting!

12

Do you know what rollover is??

13

Just to update, I think there is really something to this Kelly Criterion theory. I’ve been employing risking higher amounts per trade than is usually advisable and its worked well so for in the last 2 months of demo trading. I’ve gone from $10000 to $30000. I think my success is largely due to having an 80% success rate in trading though. I’m still just a beginner so am seeing how it goes for the next few months.

Most tutorials advise only risking 1% per trade since that way if you have a string of 10 consecutive losses you’ll only be down a few % instead of 30% or something. But equally if you only risk 1% and have a string of 10 consecutive WINS then you’ll only be up a few % instead of about 30% so it will be much easier for you to drop back into the red again. That’s something they never seem to mention in the tutorials.

The way I see it is like this:

1% risk per trade 20:1 leverage - too low, you’ll hover around your initial capital deposit level for too long and never really get anywhere. Psychologically not good either.

10-15% risk per trade 500:1 to 1000:1 leverage - too high, if you have more than a few negative trades in a row you’ll bust your whole account

5%+ risk per trade 50:1 to 100:1 leverage - just right, you’ll make good gains and equally make bigger losses but as long as you basically know what you’re doing (ie not just losing all the time) you shouldn’t bust your account too easily.

14

Try to do the same for a year or two, i doubt you can handle the pull back. Don’t cry like a baby when it happens.

15

You are actually right, 5% is basically what most professional traders risk each trade, and where the real gains are made. The key word there was PROFESSIONAL. However, the tutorials here are for babypippers, not professionals, who wouldn’t need the tutorials in the first place. Once we graduate from noobies to more advanced levels, i.e. making a higher winning to losing trade ratio, we can gradually increase the risk level based on our own risk tolerance.