In trading, there are periods when trends change whether that be in the type of technical analysis used or the instruments traded. In the early 2000’s there were Covered Warrants, then a few futures contracts slowly made their way into the picture…then options. Even bitcoin ending with the more recent Binary Options. However, the backdrop to all of these markets has always been the big shadow of the forex market, a mysterious entity that was unleashed on the world of trading taking on different meanings – in the beginning it was the mysterious and fascinating world of currencies. This soon transformed into the go to place for survivors of other markets, aided by attractive offers by various brokers and a massive advertising campaign to boot.
What attracted people to trade in the Forex market? I believe the answer lies in two main factors: The 24 hour accessibility and, above all, the leverage which was being offered.
The fact that we can trade any hour of the day or night is alluring because it gives the impression that we can reconcile our trading activities with that of the office job which “obligates” us to stay far away from the monitors during the central hours of the day. Unfortunately, many markets also appear to “punch out” of work and, as such, tend to move too slowly to create compelling trading setups. Overlooking this aspect, let’s touch on the most delicate theme linked to forex – leverage.
Figure 1: The effect of leverage
Due to the way it’s marketed, online trading is often considered a blissful oasis where you can’t help but make money or, worse still, as a way to save yourself from a difficult financial situation. Thanks to the leverage provided, forex allows us to trade with small sums of money whilst moving large amounts of capital within the markets. This allows us to amplify our winnings…or at least this is the message perceived.
In my line of work, I’m often contacted by the unemployed or people in financial difficulty who are in search of a solution to their financial woes. The general consensus is that there is a secret formula that will allow mistakes to be avoided or, at the very least, allow the gains to outweigh the losses. Assuming this to be true, people think that the logical next step can be none other than to use the aforementioned formula with as much capital as possible in order to maximize their gains.
This is where leverage enters the picture with its accompanying commercial messages: “With $1000 you can trade with $100,000 buying power!” (100:1 leverage), “Make 1% and you will DOUBLE your account…” and so on and so forth.
Are these claims lies or the truth? Everything that is said is absolutely true, the problem is what is omitted or simply “not said”, if it is in fact true that leverage can amplify your profits it’s also true that it can amplify your losses. Making 100% is as possible as losing everything. Many brokers promise the closure of open positions so that you don’t lose more than the available funds in your account. This is usually what happens but there are sometimes cases in which you can find yourself in debt with the broker. A good example is the movement of the Swiss Franc in January 2015. Whoever was long the EURCHF with extreme leverage, counting on the 1.20 level holding, found themselves with negative accounts when the Swiss National Bank made their announcement, removing the floor at that level. Not all of the brokers covered the losses that were greater than the accounts in question and some of them filed lawsuits that last until this day.
Let’s not overlook the psychological block that would probably be faced in the case of movement against a position. The newbie trader, clouded by advertising promising easy profits, would probably look on petrified as their account disintegrated before their very eyes as price continued to move against their expectations.
There are also other, more conservative messages within the industry. Messages such as, “If used correctly, leverage can amplify profits…”, but they are still missing a clear definition of what “correctly” is. The message tells us everything and nothing…it’s the “nothing” that is of concern. After all, we are dealing with our own money…
So, Forex is terrible? Is it to be avoided by newbie traders?
When someone comes to me and asks my advice on how to approach the markets with a small amount of capital, my general answer is “think about trading Forex” (actually my very first response is always to change route and forget about trading! but nobody ever listens to this…). Does this make me part of the host of reckless vendors who lure people into trading with ridiculous leverage..?
Absolutely not. For me, risk control is an essential element of successful trading. So what advantages can an under-capitalized trader find in Forex?
The real advantage in Forex lies in its enormous scalability both to the upside, due to its massive liquidity, and, more importantly, to the downside. A standard lot is 100K (I won’t specify a value as this depends on the pair used) but it’s also possible to trade with mini lots (10K) and micro lots (1K). This allows us to adjust our risk exposure and take on the appropriate risk for almost any account size.
The ability to limit the risk exposure to values that keep the negative excursion of any one position under control allows us to trade with our chosen strategies even when we have small sums of money at our disposition. We don’t need leverage to amplify, we need scalability to limit. The real secret to being able to survive in the markets as long as possible is being able to trade tomorrow. Live to fight another day! This is only possible when we still have money in our account to trade with…
Let’s suppose then that we have a strategy that, for example, requires a 50 pip stoploss on the EURUSD, what would we do?
If we were to trade with a full lot of 100K the stop would be the equivalent of a $500 loss…is that magnitude of loss sustainable? This is where we need to start. We have to ask ourselves what sort of impact that loss would have on our account.
Let’s assume we have an account of $1000 (I’m using dollars as this is the underlying currency of the EURUSD), what could we do? If we consider the fact that the exposure is 100K, it’s not a given that the broker will allow us to open a full lot. This depends on the margin limits that they enforce, but it’s this exact erroneous way of thinking that is to be avoided. We shouldn’t start by thinking about how much we can invest, we should be thinking about how much we could lose! With a full lot we’ve seen that we would lose $500 in the case of a stoploss. This would constitute 50% of our account! One could argue that we would still have half our capital left and that we could make it back with future trades. However, it goes without saying that losing 50% of your capital with one trade is madness. If someone considers trading in this manner, they can’t refer to it as trading but, rather, pure gambling. Not that there is anything wrong with such a choice…it’s just simply outside of the realm of trading.
So how much can we actually afford to lose? This is subjective and depends on many factors, from our risk profile to the type and number of strategies that we intend to use. However, a good, sensible rule suggests a starting point of 2% per trade. Some of you will be saying, “So small?!”. I assure you that that isn’t very small at all. A losing streak is always around the corner and that same 2% could easily land you in a 10-20% drawdown without even realizing it. 2% isn’t a value for scared traders, unsure of the validity of their strategies. It’s a sensible starting point that will obviously be personally reconsidered by each trader based on the above factors.
Returning to our example, what would that mean? 2% of $1000 is $20 and this would be the maximum that we would be willing to lose in that trade. To make sure that the 50 pip stop doesn’t result in losses that exceed this, we have to calculate the size of the position:
If 500 equivalates to a size of 100K, what size do we need for 20?
20 : X = 500 : 100.000
500* X = 20* 100.000
X = 20*100.000/500 = 4.000
Our position can be opened with 4 micro lots.
If instead of Forex we had chosen the futures market, we would have had to go with the 6E (EURUSD futures contract). In this case, the 50 pips would be the equivalent of $625 and we wouldn’t have had any way to risk any less as we wouldn’t have been able to buy a fraction of a contract. The same goes for the micro 6E (M6E) contract. This is valued at a 10th of its larger counterpart and would have resulted in a loss of $62.50…still too much for the size of our account.
It must be said that trading stocks also offers a remarkable scalability towards the downside but the lower exposure is often hit by excessive transaction costs. Only a few brokers offer low commissions without a minimum…in general, there is a fixed minimum per transaction and this cost is usually too high for the reduced position size. Forex is a different situation where you either pay a spread proportional to your exposure or you pay an additional commission which is also proportional to the lot size.
Here is a table which summarizes some of the fundamental principles we have discussed:
All of the above is intended for whoever, at the beginning of their journey, doesn’t want to/can’t dedicate significant capital towards trading. But once a sufficient amount of capital is available, are there still advantages in trading Forex rather than Futures?
Taking into account the list of pros and cons and any personal bias towards trading one market over another, there is another aspect, which is still linked to the greater scalability of Forex compared to that of futures, that might make the former more appealing.
Considering the calculation of the size shown above underlines the fact that scaling is more complex when trading Futures insomuch as you are unable to use fractions of contracts. For this very reason, the ability to increase size as your account grows is inhibited…you have to wait until you have the capital necessary to move from 1 contract to 2 (or from any given number of contracts to the next whole number). Whereas in Forex, thanks to micro lots, it’s possible to increase your exposure gradually in harmony with the growth of your trading account.
This way, using a strategy with positive expectancy (that will grow our account over time), we have a greater advantage trading Forex as we are able to use position sizing in a very precise way and trade size which more closely resembles the ideal size for our account and/or strategies.
On the EURUSD pair, the corresponding exposure of the 6E is equal to 125K. Obviously with futures we are obliged to trade 1 contract until such time as our trading capital allows us to move to trading 2 contracts. Whereas in Forex, moving from 125K to 250K (i.e. 2 6E contracts) can be done much more gradually at a rate of 1K per size increase.
To demonstrate this concept using actual numbers, let’s look at the following graph. It shows a given number of trades that were taken both in the EURUSD pair and the 6E futures contract. The size for both was calculated periodically and increased as described earlier in this article.
In figure 2, the two equity resulting equity lines are shown. The greater scalability in Forex allowed for a better final result when compared with that of the 6E futures contract.
Figure 2: PnL curve using the EURUSD or the 6E