forex Archives - Algorithmic and Mechanical Forex Strategies

Introduction To Binary Options Trading, Part One

February 17, 2015 by Eddie Flower 8 Comments

What are binary options, and why are they so popular?

In the world of finance and trading, a binary option, also sometimes called a “digital option,” is a cash-settled, European-style option that can be exercised only on the expiration date. There are only two possible outcomes: The payoff is all or nothing, hence the name.

Unlike the older generation of options whose expirations might lead to unpredictable outcomes upon expiration, the purchaser of a binary option receives a predetermined amount; likewise, an out-of-the-money option expires worthless.

So, those who trade binary options receive a predetermined amount of cash if the option expires “in the money.” For this and other reasons, online binary options trading has become enormously popular.

Binary options have gained acceptance among a wide range of traders. They’re popular with both institutional investors and traders on the exchange floor, as well as independent “prop traders” working online with forex.

Why trade binary options?

Less sensitive to market conditions

The traditional financial markets have been recovering very slowly from the sluggish worldwide economy, yet the newest generation of forex and binary options trading platforms have allowed savvy traders to trade continuously – even while equities and other investments have lagged behind.

For agile independent traders, binary options may lead to more opportunities, often many more than those through spot forex trading alone.

Quick turnaround

The quick turnaround in expiration dates allows traders to bridge multiple markets in real time, so binary options offer a way to be active worldwide markets through 24/7 online trading. Traders can quickly use their account equity by using mobile trading tools to access the marketplace.

Manageable risk — Predetermined profits & losses

Although any form of investment or speculation can be risky, many traders, especially those focused on forex trading, have been attracted to binary options trading because the possible downside to any given trade is completely known beforehand. Unlike commodities or other derivatives in which the holder may be exposed to unlimited risk, the maximum risk with binary options is known in advance.

One major benefit is the trader’s ability to fix the amount of potential loss (and gain) at the start of the trade. The combination of known returns and lowered risk compared to spot forex trading or old-style options trading has led many of those traders to switch to binary options.

Simplicity, accessibility & affordability

Put simply, a binary option trade represents the trader’s belief that the price of the underlying market will rise or fall by the time of expiration of the option. In contrast, the older generation of options requires a clear idea of the magnitude of the anticipated market move as well as its direction.

To trade binary options successfully, a trader needs only to have an idea of the direction of the price of the underlying market over a fixed period of time. Then, buy or sell accordingly.

Accessibility is the key to success for binary options traders – For traders who rely on mobile trading access such as for Android iPhone forex trading and other online platforms, the accessibility of binary options means that business professionals in any niche, even medicine and law and other busy professions, can trade profitably at their own convenience, almost any time of day or night.

Affordability is another reason why binary traders participate in this market. Traders with limited resources who begin trading binaries have reported significant gains, and many small, independent traders are able to economically build their own trading businesses part-time, while continuing in other careers as well.

Should you start a forex broker?

January 22, 2015 by Shaun Overton 4 Comments

A friend of mine in Ireland was absolutely convinced that I should set out and start my own forex brokerage. Don’t you just buy a MetaTrader license and the money starts rolling in?

Photo credit: taxcredits.net

Instead of trying to persuade him why I wasn’t in a position to succeed, I told him a few stories about people that have done well opening their own forex broker.

Who succeeds as a forex broker?

Some of the most successful brokerage owners are immigrants to English speaking countries like the US, Ireland or Australia. They’ve started businesses before and have done well for themselves. Most of these immigrant entrepreneurs have a large number of family members back home that are eager and willing to help launch a new venture.

I put together a few entrepreneur profiles to show who tends to do well in this type of business.

The local option

Hinh left Vietnam in the early 1990s for better opportunities in Canada. He’s done well for himself operating a local restaurant chain. Although he’s been gone for 20 years, he regularly travels to Vietnam to visit uncles and cousins.

His relatives recently started trading forex and sensed a business opportunity. There are almost no brokerages in the country with a local office. Nobody feels really comfortable with the current options out there, but where else can they trade?

The cousins and their sons have been introducing a few accounts to the major brokerages but feel like they’d do a lot better keeping everything in house. Maybe Hinh could put up the seed money to start a new business that can cater to local needs?

The cousins start running seminars for their friends and neighbors about forex. People like the idea of managing their own investments and open their accounts based on the trust and relationships they’ve built with Hinh’s extended family.

The specialist firm

Thomas is a British investor living in Portugal with his Russian wife Anna. He’s been dabbling in the forex market as for five years. It’s only recently that he feels like his investment abilities are put to better use in currencies than shares.

If he were to raise funds for investment in the stock market, he’d spend a king’s ransom before he was legally permitted to earn a penny. Focusing on FX allows him to raise money from around the world with significantly less money up front.

He also knows that his reputation is on the line, so he doesn’t want to pick a firm out of thin air. Thomas believes he’ll do far better running everything entirely on his own.

He starts a broker and, largely on a hunch, decides to target Russia, South Africa and Mexico. Partly from two decades of international travel and partly due to luck, Mexico happens to be a market that’s very receptive to managed funds products.

Thomas has a background in marketing and sales, allowing him to identify high net worth investors quickly. After making a few business trips between Portugal and Mexico, he lands the accounts that he needs. As he establishes himself over the next two years, his brand becomes associated with quality managed accounts and trust with larger deposits.

Why forex and what’s my competitive advantage?

Immigrant entrepreneurs do well with forex due to the underdevelopment of their home countries. Consider the example of Hinh from Vietnam. The local stock market is not noteworthy. There’s no such thing as an IRA account or municipal bonds that you go buy for your retirement account.

People with savings need to put that money to work. Running a global forex brokerage offers that capital an outlet to international markets. It doesn’t really have anywhere else to go.

At the moment, there’s not a lot of competition in these emerging markets for local brokers that build relationships on a person to person level. Running Google Ads and the usual online marketing tactics are saturated.

The one way in which the FXCMs and Saxo Banks of the world cannot compete is on personal relationships. If you or your family members are good at networking and can show new traders how to succeed in the market, you have an edge that is difficult to compete against.

What you might see as your disadvantage, being a new broker in the market, is actually one of your biggest strengths. You’re not yet worth competing against. That will undoubtedly change in a few years as the idea of forex establishes itself in frontier markets.

Assuming that you succeed in your home country, the global nature of the market gives you worldwide opportunities for expansion. It’s common for someone to incorporate in Spain, run their operations from India and run a sales team in the Philippines.

An enormous percentage of internet users know some degree of English, at least enough to open and maintain a forex account. The barriers to trading are also fairly low; anyone with a cell phone and basic English can manage a trading account. The presence of a common language allows brokers to expand and run their operations where time zones and costs present an advantage.

The best candidates for launching a broker are IBs with a substantial client base. They usually run in-person classes, manage money or have a substantial internet presence. It’s not all necessary to be great at everything. Most start up brokerages find a niche within the trading community and use that as a base to build from.

How much money do I need to invest to be successful?

A forex brokerage is a financial institution. If you’re going to do start a brokerage and expect to do well, an investment of $100,000 is a reasonable starting point. That amount of money should cover the following:

Incorporation and initial legal compliance costs
Technology setup and maintenance costs for the first year
A sufficient marketing budget to open new accounts
Staffing to run the operation 24 hours a day, 5 days a week

Like any new venture, some businesses do well and others don’t. According to Erich Grant, head of the Start A Broker (SAB) program at Shift Forex, the brokers that thrive tend to turn a profit within the first 6 months.

Given the risk involved, it’s important to identify your personal advantages and whether the potential opportunity is large enough to justify the risk. Email info@onestepremoved.com to learn more details on starting your own FX broker.

Free blow up insurance?

January 19, 2015 by Shaun Overton 17 Comments

Last week’s drama with the collapse in the EURCHF peg hammers home an uncomfortable truth: you can lose more in your account than you deposit.

Trading on leverage is inherently dangerous. Although an instant 20% move in a major currency is a once in a lifetime event, it goes to show just how quickly the markets can charge over alleged safety features.

Did placing a stop loss at 1.19 for an open EURCHF trade do any good last week? Not a bit! As soon as the market breached 1.20, it instantly gapped down 10%.

When markets go bidless, it means that there is no liqudity in the market. That’s jargon that means everyone is too scared to do any buying or selling. There literally is no price at the moment where anyone is willing to trade.

It was at 1.20. The next thing you see is 1.08 and the price falling fast.

I was fortunate enough to be awake at 3 a.m. when the proverbial cow-pie hit the fan. Although I’m an alogrithmic trader, I confess that my immediate instinct was to hop on the bandwagon and buy!, Buy!, BUY! all the Swiss francs that I could handle (when you go short EURCHF, you’re selling euros and buying francs).

Every inch of my body wants to go short with the $EURCHF collapse, but I run an algo system and I’m sticking to it.
— OneStepRemoved.com (@_OneStepRemoved) January 15, 2015

The way I coped with the urge was to IM a friend and pass a running commentary on the insanity. Posting on Facebook and Twitter also kept me busy. Basically, it was a strategy to keep myself wholly occupied and distracted so that I wouldn’t be tempted to jump in.

I’ve seen mega moves before and, more importantly, I know from experience how badly people can get hurt. My favorite war story from working as a broker was a wealthy client in Kuwait that opened an account with $250,000 the night before NFP. He went long on 100:1 leverage and of course the report was the complete opposite of expectations. The market gapped instantly and before his trade could close, his account balance was -$20,000.

You don’t read stories like this on the forums because… who on earth wants to go advertise their financial destruction on the internet? It’s embarrassing and, if we’re honest with ourselves, that person is probably doing everything humanly possible to not think about their situation.

Nobody raised their hand to tell me about catastrophic losses in the CHF

Free insurance

The primary reason to trade with maximum leverage is because it’s like free insurance against devastating losses. You never know when a peg will go bust or the next 9/11 is going to happen.

Let’s game this out. You were long USDCHF on Thursday and there was no stop loss in the world that could protect you against an instant 10% gap. Consider two scenarios:

You had a $30,000 account balance and were trading an institutional level of leverage like 5:1. That means your position value was 30k * 5 = $150,000. The instant gap created a loss of 10% * $150,000 = $15,000.
You had a $3,000 account and were trading the “crazy” leverage of 50:1. The position value was also $150,000 and yields a $15,000 loss.

Now let’s talk about what happens in the real world. In the first sceario, the money is on deposit with the broker and you 100% have lost $15,000. It’s a guaranteed fact and you can safely kiss the money goodbye.

In the second scenario, you may legally owe the broker $12,000 (3k-15k=-12k). However, what is the broker’s likelihood of recovering the money? If you’re in the UK and you trade at Pepperstone in Australia, they’d have to sue you in an Australian court. The attorney’s fees alone would be several thousand dollars. And most convincingly, you probably don’t have any assets that the court could award to the broker.

Even if you are in Australia, think about all the bad PR hitting the forums when the big dog starts suing little retail traders. There’s almost no business-case for pursuing the negative balances of retail forex traders.

You’re going to see a lot of hooplah this week about brokers “forgiving negative balances.” It’s great PR and it’s the best way for them to play it. They know darn well that there’s almost no chance of recovering that money. It’s the best way to turn lemons into lemonade because the brokers lost an epic amount of money.

How to protect yourself

Chris Zimmer, the programmer here at OneStepRemoved, sent me this as soon as the day ended.

I was already on board with it but this recent event makes your method of pulling money out of FX accounts look very obvious.
I just checked and the USDCHF dropped over 1600 pips on that bar. That really hits close to home as we could have easily been Long that pair and something tells me any stop would not have been filled.

Trade on leverage and, for goodness sake, withdraw the money at regular intervals. Nobody can take it away if you don’t keep it in their hands.

Did your broker go bankrupt this morning?

January 16, 2015 by Shaun Overton 6 Comments

It’s an absolute bloodbath in the FX markets. The tide’s gone out and it’s now very apparent who has good risk management systems in place and who was reckless safeguarding your deposits.

Is your broker on this list?

Alpari – bankrupt!
FXCM – took an enormous $225,000,000 loss on clients with negative balances. It’s desperately seeking a bailout.
EXCEL Markets – bankrupt!

FX brokers are led to the slaughterhouse.

One of first articles that I send traders on the free EAs list is how to protect yourself from a forex broker bankruptcy. It’s absolutely, critically important where you decide to trade.

I trade at Peppertsone and I strongly recommend that you trade at Pepperstone, too. They made it through this crisis unscathed. They’re well regulated. They’re in a safe and stable banking jurisdiction. And… they’re still running a thriving business.

PS: QB Pro made it through the CHF chaos unscathed. We closed out with a nice profit yesterday.

The importance of Monday Morning quarterbacking

December 28, 2014 by Eddie Flower Leave a Comment

As described in previous articles in this series about how to win as a prop trader, managing your forex business like a prop trading shop increases your chances of winning. Successful prop traders use maximum leverage with limited account size, and they pull profits regularly to limit risk in case of a trading system “blow up” resulting in a steep account drawdown.

Monday-morning quarterback wins the game

According to many traders, a trading system’s performance never stays the same: either it improves, or it becomes worse, perhaps even “blowing up.” Although Monday-morning quarterback is often derided for criticizing or suggesting alternative courses of action in hindsight after an event, performance review is critically important for trading success going forward.

Critical review of previous trades and system performance means the difference between success and failure for prop traders, especially for those who are responsible for leveraging other investors’ capital.

Independent traders must evolve by ruthlessly facing and correcting their shortcomings, or become extinct by losing their trading capital.

And, beyond remedying the causes of losing trades, Monday-morning quarterbacking also works to examine and highlight the winning characteristics of particular trades. Shaun and other successful prop traders look beyond the emotion of the trading moment to make sure that subsequent trades are even better.

System review and human review

If you’re trading manually with discretion, think about what you could do differently in order to help you focus and perform better, with less stress and more discipline in your decision-making protocols.

If you’re trading with a mechanical system, think about whether the performance of your live account matches the expected results from your back-tests during the same time frames. If not, find out the reasons for the discrepancies, and you’ll earn more money as a trader.

Ask the difficult questions early, avoid the errors later

As a mechanical trader, you should also plan ahead to avoid or quickly adapt to any negative situation or market scenario that might cause your system to fail, even temporarily.

By thinking carefully about previous trading glitches and losses in search of valuable lessons, you’ll be able to minimize the impact of those events if they occur in the future.

Prop traders thrive with the right tools

Prop traders can thrive with the right performance-enhancing tools, especially when using trading systems built and managed by experts. The first step toward successful prop trading is to ask the difficult questions about current performance, and then fully address all issues that are discovered during the critical review.

Shaun’s Recommended Forex Brokers

October 21, 2014 by Shaun Overton 99 Comments

There are only three questions you need to ask when you’re looking for a forex broker:

Are you going to give me excellent execution with low commissions and spreads?
Are you going to send my money back within 24 hours?
Are you likely to go bankrupt in the near future?

If a broker ticks those boxes, then picking a broker is really just a commodity. I don’t need market analysis or the latest trendy tool. The only reason I’m trading forex is to make as much money as quickly as possible (and to keep it) .

Too many brokers have gone belly up. I put together this guide to help you make an informed decision about who to trust and who offers the best deals.

Shaun’s broker recommendations

Pepperstone is where I trade my live accounts, which says everything. My money is sitting at this broker right now. I’ve met Owen Kerr, the CEO, in person and have a friend in their Dallas office. I’m very comfortable with their banking relationships. They also offer extremely competitive pricing.

ILQ caters to large retail customers (people that trade 100mm in monthly volume or more) or CTAs and independent money managers. The upper echelon audience means they do those three important things right. ILQ has a solid reputation in the industy, and based on the endorsement of a colleague that trades with them, I’m comfortable recommending them to my readers.

MB Trading is a US firm that offers the only true ECN available to retail traders. When you post a limit order and it’s better than the best bid or offer, your price shows up in the terminal window. They also offer liquidity rebates, which I’m a big fan of. I’ve known Justin LeBlang for several years and held live account with MB Trading for two years. They’re support is best in class and the technology and pricing is excellent.

Are you concerned about broker shenanigans? Learn how to protect yourself against forex broker bankruptcies.

Risk Management – Deciding When To Hold, And When To Fold

October 10, 2014 by Eddie Flower 5 Comments

There’s a proverb among old forex traders: If you put two newbies in front of the same trading screen and arm them with the same tools, and if each takes the opposite side of a given trade, both will probably lose money, regardless of the final direction of the price move.

Yet, if you put two highly-experienced traders into positions in opposite directions, very often both of them will win the trade or at least break even, in spite of their contradictory trading positions.

Why?

The difference between rookie traders and pros is risk management. In the trading game, successful risk management is the key to survival. Many beginning traders pay lip service to the idea of managing risk effectively, yet few have the discipline to follow through entirely, even with the power of mechanical trading systems.

Regardless of the exact forex trading strategy or system, loss-taking is a critical component for long-term success.

Any forex newbie can exit from winning trades, but it takes an experienced trader to slip out of losing trades relatively unscathed. In this article I’ve outlined several perspectives on risk management strategies used by successful forex traders across a wide range of markets.

Forex risk management

Most forex traders have a clear idea of their own investment objectives and tolerance for risk. And, most already know that appropriate risk management is crucial for success in any form of trading.

The best trading risk management means using a standard process to identify and analyze risks, then either accepting, mitigating, or rejecting them. For traders, it comes down to finding and assessing opportunities, then quickly acting on or declining those trades.

Basic risk management is two simple steps – Discovering and determining the risks within an investment, then responding to those risks in the best possible way to meet the investment objectives.

Some risks are considered intrinsic risks, or built into the system, while other types of risks are extrinsic in origin. In any event, forex traders have a variety of tools and metrics for assessing risks and setting parameter values. From that point onward, it’s up to the mechanical trading system to work its magic.

Mechanical risk management

Even when relying on mechanical systems, successful traders must be well disciplined and adhere to carefully-planned forex risk management and trade-exit strategies. That’s because people have a natural emotional aversion to taking trading losses, even when necessary.

Mechanical trading systems can help manage risks by better choosing and executing trades, and constantly monitoring positions. They add a layer of impartiality to lightning-fast analysis and trade execution. Yet, there is always room for human error in system design.

Speed plus reduced human oversight equals an increased possibility of trading loss. Mechanical risk management methods must be carefully vetted and tested before they’re implemented.

Most traders are closely focused on the “front end” of forex trading, that is, how to find a winning trade and enter a position at the right point. Other than basic stop-loss orders, few traders think carefully about how best to exit from the trade.

For the long-term survival of any trading system, whether manual or mechanical, the most important issue is how and when to exit from trades. Although less glamorous than the work of crafting a winning entry strategy, the task of building a successful risk management and exit strategy is crucial for success.

Lose your bad trades as soon as possible

Most traders are already aware of the mathematical difficulty of overcoming losses – As shown in the drawdown in Table 1 below, the more the trading-account equity is drawn down, the higher the percentage of subsequent gains required simply to break-even.

Table 1

Lose 25%, must regain 33% to break even
Lose 50%, must gain 100% to break even
Lose 75%, must gain 400% to break even
Lose 90%, must gain 1000% to break even

For example, after losing 50% of the trading account equity, the eventual winning trades would need to earn 100%, i.e. double the account size, simply to break even. Worse, at a 75% drawdown level, a trader would need to quadruple his or her account equity just to reach its original level.

Obviously, very few traders could achieve such a comeback. It’s far better to manage drawdowns by exiting each trade appropriately. Taking each loss at the optimal time allows the trader to stay in the game as long as possible, even after a long string of losing trades.

The runaway loss

Most traders have heard war stories about a single bad forex trade eating up days, months or even years of profits in one gulp. When a runaway loss occurs, it’s more likely the result of error in human judgment rather than from a glitch in the mechanical trading system.

Usually, catastrophic losses result from poor or non-existent risk management, failure to use “hard” stop-loss orders, and multiple trades in which the losses from the average losers are greater than the gains from the average winners.

A runaway loss shows lack of discipline. Instead of becoming enchanted by the dream of scoring “one big winner,” the more prudent strategy for trader survival is to focus on avoiding big losses.

The Golden Rule of Risk Management: Position risk limit

Ironclad stop-loss orders prevent runaway losses. According to the trader’s appetite for risk, the mechanical trading system can set risk limits according to account equity, position size and other parameters, as described later in this article.

Many forex traders advocate a “Golden Rule” of risk management based on position size or position risk limit. They recommend the at-risk account equity should never be more than 1% (conservative) or 2% (liberal) on any single trade position.

From a psychological standpoint, the trader can be indifferent to the outcome of any particular trade when only one or two percent of the account equity is at stake.

And, from a mathematical perspective, it’s important to point out that by risking only 1% to 2% per trade the system can lose repeatedly without approaching the drawdown levels shown in Table 1 above.

Regardless of the mechanical forex system being used, the trader should use only speculative capital. When asked by newbie traders how much money they should use to trade a given system, one well-experienced trader recommends choosing a funding amount which if entirely lost wouldn’t affect the newbie’s sleep at night.

Risk management styles

There are two general styles of successful risk management. Some managers refer to these opposite styles as either the “home run” approach or the “singles and doubles” approach.

On the one hand, a forex trader may choose to take frequent small losses and break-evens while working to harvest all profits from the relatively few big winning trades. Or, a trader may decide to seek many little gains and use infrequent but relatively large stop-losses with a system designed to accumulate the small profits and outweigh the losses.

The trading psychology is more important than the mechanical trading strategy itself. Taking many small losses tends to cause numerous painful twinges, interspersed with occasional moments of pure ecstasy.

In contrast, the “singles and doubles” risk management style offers plenty of minor joys, punctuated by some nasty psychological blows.

The best choice of trading style largely depends on the trader’s personality. A new trader will usually quickly discover which general style best fits his or her personality.

One of the major benefits of forex trading as compared with stock trading is that the forex marketplace easily accommodates both types of trading styles, using many different trading systems.

Since currency pairs trading is a spread-based marketplace, traders shouldn’t be too constrained by the number of round-trip transactions required by any given strategy.

For example, in the EUR-USD market, traders might find a 3-pip spread that’s the same as the cost of three one-hundredths (3/100) of one percent (1%) of an underlying position. This cost is generally uniform, in terms of percentage, regardless of whether the trader is dealing with one-million-unit lots or 100-unit lots of the same currency.

So, if a given trading strategy required 10,000-unit lots, the amount of the spread would be $3, yet for that same trade executed only using 100-unit lots, the spread would be a tiny $0.03.

This is in sharp contrast to the stock market, where the commission on 1000 shares or 100 shares of a stock valued at, say, $20 might be fixed at a total commission of $40.

That means the effective commission cost for the stock-market transaction might range between 0.2% to 2%, thus affecting the trader’s choice of risk management style.

Variability in commission percentages makes it difficult for small traders in the stock markets to scale into their positions because of these skewed commission costs. Yet, forex traders benefit from uniform pricing, so they can use either risk management style.

This freedom of risk management style has drawn many independent traders away from equity markets to forex markets.

4 basic types of stops

Another foundational choice to be made by forex traders based on personality and trading strategy is the type of stop to be used for risk management. There are four basic types of stops:

Equity stop

An equity stop is the simplest type of stop for mechanical trading systems. For any given trade entry, the system calculates a fixed percentage of the account equity, usually between 1% and 2%, as outlined earlier in this article.

For example, for a $10,000 forex account, the trader’s system could risk up to $200, or up to 200 points, on a single mini lot (of 10,000 units) of the EUR-USD currency pair, or up to 20 points on the standard lot with 100,000 units.

Aggressive traders sometimes consider 5% equity stops, that is, a position risk size of not more than 5% of the account equity. This limit is often considered the upper limit for prudent risk management.

Recalling the equity drawdown shown in Table 1 above, it can be seen that with a 5% equity stop 10 consecutive losing trades will cause a 50% drawdown in the trading account.

Also, it should be said that the biggest drawback of using an equity stop is it enforces an arbitrary exit point based on risk management alone, instead of exiting the market as a logical response to price movements.

Still, mechanical trading systems can thrive by using equity stops, especially when combined with other indicators to confirm trading signals.

Chart stop

Mechanical trading systems and expert advisors (EA) use a myriad of technical indicators to generate hundreds or thousands of potential stop levels. The best risk management methods combine the features of both equity stops and technical indicators to calculate chart stops.

One typical example of the chart stop is a swing high/swing low level. In the chart below, a $10,000 trading account with a mechanical system using a chart stop might sell one lot and risk 150 points, about 1.5% of the account’s equity.

Volatility stop

Mechanical trading systems often rely on more sophisticated logarithms to calculate risk parameters based on volatility instead of price movements alone. In any high-volatility marketplace, where prices show wide ranges, the trading system must adapt to the ambient volatility.

This helps the trader avoid being stopped out prematurely by market “noise.” And, the same holds true in low-volatility markets, where the system should constrict the risk parameters in order to avoid giving back profits before successfully exiting from positions.

One of the easiest ways to monitor volatility is by using Bollinger Bands, which rely on standard deviation calculations to measure variations in price. The two charts below illustrate high volatility and low volatility stop levels by using Bollinger Bands.

As seen in the first chart, a volatility stop lets the trading system employ a scale-in method in order to achieve better overall blended pricing and a quicker break-even level.

Of course, since total position risk shouldn’t be more than 2% of the equity in the trading account, the system choose smaller lot sizes to best fit the total position risk.

Margin stop

A margin stop is a form of risk management used by some cautious traders to reduce the risk and psychological pressure when beginning to trade an entire account by using a single new strategy or system. If used carefully, it can be effective in most markets.

Since forex markets operate twenty-four hours per day, it means that forex dealers could liquidate traders’ positions fairly quickly in case of margin calls. For this reason, forex customers are rarely in danger of generating a negative balance in their account, since computers automatically close out all positions.

The margin-stop risk management strategy is based on the trader’s total capital being divided into various allotments for each of one or more new or different trading strategies and systems.

For example, assume the trader is investing a total of $10,000 into forex trading, and he or she wishes to focus individually on trying 5 different trading systems and strategies in order to determine objectively which is the best “fit” for the trader.

So, the trader will open the forex account by wiring only $2000 from his or her bank account, assuming that each of the 5 receives the same funding proportion. If a forex broker offers leverage of 100-to-1, the $2000 deposit might allow the trading system to control two standard 100,000-unit lots.

Even better, depending on the trader’s risk tolerance and management, the system may trade using a 50,000-unit lot position. That might allow room for as much as 100 points.

As successive strategies are funded and launched exclusively, it’s easier to account for wins and losses due to individual approaches. It allows developers to refine their systems. And, traders enjoy more peace of mind by knowing that an unforeseen “blowup” won’t terminate their trading.

In any event, the primary purpose of the margin stop is to prevent a runaway loss from occurring during the launch of a new strategy or trading system. It also helps enforce discipline in risk and money management.

Know when to hold and when to fold

In conclusion, it can be said that trading success is based on surviving losing trades long enough to finally develop a consistently-winning system. Each forex trader should carefully consider his or her risk tolerance, and craft a risk management strategy to fit.

Mechanical trading systems make it easy to find good entry points, yet it’s just as important to have a sold risk management strategy, plus the tools to determine an exit point immediately after entering any position.

After all, taking the right loss at the right time is a necessary part of the game.

What are your thoughts about losses?

Comprehensive Guide to the Turtle Trading Strategy

March 31, 2014 by Eddie Flower 16 Comments

Turtle trading is the name given to a family of trend-following strategies. It’s based on simple mechanical rules to enter trades when prices break out of short-term channels. The goal is to ride long-term trends from the beginning.

Turtle trading was born from an experiment in the 1980s by two pioneering futures traders who were debating whether good traders were born with innate talent, or whether anyone could be trained to trade successfully. The turtles developed a simple, winning mechanical trading system that could be used by any disciplined trader, regardless of previous experience.

The “turtle trading” name has been attributed to several possible origins. For me, it epitomizes the “slow but sure” results from this system. In contrast to complex black box systems, turtle trading rules are simple and easy enough for you to build your own system — I highly recommend it.

The earliest forms of turtle trading were manual. And, they required laborious calculations of moving averages and risk limits. Yet, today’s mechanical traders can use algorithms based on turtle parameters to guide them to successful trading. As always, the key to trading success lies in consistent discipline.

Which markets are best for turtle trading?

Your first decision is which markets to trade. Turtle trading is based on spotting and jumping aboard at the start of long-term trends in highly-liquid markets, usually futures. Since long-term trend changes are rare, you’ll need to choose liquid markets where you can find enough trading opportunities.

My favorites are on the CME: For Agriculturals, I like Corn, Soybeans, and Soft Red Winter Wheat. The best equities indexes are E-mini S&P 500, E-mini NASDAQ100, and the E-mini Dow. In the Energy group, I like E-mini Crude (CL), E-mini natgas and Heating Oil.

And, in Forex, it’s AUD/USD, CAD/USD, EUR/USD, GPB/USD, and JPY/USD. From the Interest Rate group of derivatives, I like Eurodollar, T-Bonds, and the 5-Year Treasury Note. Finally, in Metals the best candidates are always Gold, Silver and Copper.

Since turtle trading is a long-term undertaking with a limited number of successful entry signals, you should pick a fairly broad group of futures. Those above are my favorites, although others will work as well if they’re highly liquid. For example, in the past I’ve traded Euro-Stoxx 50 futures with excellent results.

Also, I only trade the nearest-month contracts, unless they’re within a few weeks of expiration. Above all, it’s critically important to be consistent. I always watch and trade the same futures.

Position size

With turtle trading, you’ll strike out many times for each home run you hit. That is, you’ll receive many signals to enter trades from which you’ll be quickly stopped out. However, on those few occasions when you’re right, you’ll be entering a winning trade at precisely the right moment – the beginning of a long-term change in trend.

So, for risk management your survival depends on choosing the right position size. You’ll need to program your mechanical trading system to make sure you don’t run out of money on stop-outs before hitting a home run.

Constant-percentage risk based on volatility

The key in turtle trading is to use a volatility-based risk position which remains constant. Program your position-size algorithm so that it will smooth out the dollar volatility by adjusting the size of your position according to the dollar value of each respective type of contract.

This works very well. The turtle trader enters positions which consist of either fewer, more-costly contracts, or else more, less-costly contracts, regardless of the underlying volatility in a particular market.

For example, when turtle trading a mini contract requiring, say, $3000 in margin, I buy/sell only one such contract, whereas when I enter a position with futures contracts requiring $1500 in margin, I buy/sell 2 contracts.

This method ensures that trades in different markets have similar chances for a particular dollar loss or gain. Even when the volatility in a given market is lower, through successful turtle trading in that market you’ll still win big because you’re holding more contracts of that less-volatile future.

How to calculate and capitalize on volatility – The concept of “N”

The early turtles used the letter N to designate a market’s underlying volatility. N is calculated as the exponential moving 20-day True Range (TR).

Described simply, N is the average single-day price movement in a particular market, including opening gaps. N is stated in the same units as the futures contract.

You should program your turtle trading system to calculate true range like this:

True Range = The greater of: Today’s high minus today’s low, or today’s high minus the previous day’s close, or the previous day’s close minus today’s low. In shorthand:

TR = (Maximum of) TH – TL; or TH – PDC; or PDC – TL

Daily N is calculated as: [(19 x PDN) + TR] / 20 (Where PDN is the previous day’s N and TR is the current day’s True Range.)

Since the formula needs a previous day’s value for N, you’ll start with the first calculation just being a simple 20-day average.

Limiting risk by adjusting for volatility

To determine the size of the position, program your turtle trading system to calculate the dollar volatility of the underlying market in terms of its N value. It’s easy:

Dollar volatility = [Dollars per point of contract value] x N

During times when I feel “normal” risk-aversion, I set 1 N as equal to 1% of my account equity. And, during times when I feel more risk-averse than normal, or when my account is more drawn-down than normal, I set 1 N as equal to 0.5% of my account equity.

The units for position size in a given market are calculated as follows:

1 unit = 1% of account equity / Market’s dollar volatility

Which is the same as:

1 unit = 1% of account equity / ([Dollars per point of contract value] x N)

Here’s an example for Heating Oil (HO):

Day High Low Close TR N

1 3.7220 3.7124 3.7124 0.0096 0.0134

2 3.7170 3.7073 3.7073 0.0097 0.0132

3 3.7099 3.6923 3.6923 0.0176 0.0134

4 3.6930 3.6800 3.6838 0.0130 0.0134

5 3.6960 3.6736 3.6736 0.0224 0.0139

6 3.6820 3.6706 3.6706 0.0114 0.0137

7 3.6820 3.6710 3.6710 0.0114 0.0136

8 3.6795 3.6720 3.6744 0.0085 0.0134

9 3.6760 3.6550 3.6616 0.0210 0.0138

10 3.6650 3.6585 3.6627 0.0065 0.0134

11 3.6701 3.6620 3.6701 0.0081 0.0131

12 3.6965 3.6750 3.6965 0.0264 0.0138

13 3.7065 3.6944 3.6944 0.0121 0.0137

14 3.7115 3.6944 3.7087 0.0171 0.0139

15 3.7168 3.7100 3.7124 0.0081 0.0136

16 3.7265 3.7120 3.7265 0.0145 0.0136

17 3.7265 3.7098 3.7098 0.0167 0.0138

18 3.7184 3.7110 3.7184 0.0086 0.0135

19 3.7280 3.7200 3.7228 0.0096 0.0133

20 3.7375 3.7227 3.7359 0.0148 0.0134

21 3.7447 3.7310 3.7389 0.0137 0.0134

22 3.7420 3.7140 3.7162 0.0280 0.0141

For HO the dollars-per-point is $42,000 because the contract size is 42,000 gallons and the contract is quoted in dollars.

Assuming a turtle trading account size of $1 million, the unit size for the next trading day (Day 23 in the above series) as calculated using the value of N = .0141 for Day 22 is:

Unit size = [.001 x $1 million] / [.0141 x 42,000] = 16.80

Because partial contracts can’t be traded, in this example the position size is rounded downward to 16 contracts. You can program your algorithms to perform N-size and unit calculations weekly or even daily.

Position sizing helps you build positions with constant volatility risk across all the markets you trade. It’s important to turtle-trade using the largest account possible, even when you’re trading only minis.

You must ensure that the fractions of position size will allow you to trade at least one contract in each market. Small accounts will fall prey to granularity.

The beauty of turtle trading is that N serves to manage your position size as well as position risk and total portfolio risk.

The risk-management rules of turtle trading dictate that you must program your mechanical trading system to limit exposure in any single market to 4 units, your exposure in correlated markets to a total of 8 units, and your total “direction exposure” (i.e. long or short) in all markets to a maximum total of 12 units in each direction.

Entry timing when turtle trading

The N calculations above give you the appropriate position size. And, a mechanical turtle trading system will generate clear signals, so automated entries are easy.

You’ll enter your chosen markets when prices break out from Donchian channels. Breakouts are signaled when the price moves beyond the high or low of the previous 20-day period.

In spite of the round-the-clock availability of e-mini trading, I only enter during the daytime trading session. If there’s a price gap on open, I enter the trade if the price is moving in my target direction on open.

I enter the trade when the price moves one tick past the high or low of the previous 20 days.

However, here’s an important caveat: If the last breakout, whether long or short, would have resulted in a winning trade, I do not enter the current trade.

It doesn’t matter whether that last breakout wasn’t traded because it was skipped for any reason, or whether that last breakout was actually traded and was a loser.

And, if traded, I consider a breakout a loser if the price after the breakout subsequently moves 2N against me before a profitable exit at a minimum 10 days, as described below.

To repeat: I only enter trades after a previous losing breakout. As a fallback to avoid missing out on major market moves, I can the trade at the end of a 55-day “failsafe breakout” period.

By adhering to this caveat, you will greatly increase your chance of being in the market at the beginning of a long-term move. That’s because the previous direction of the move has been proven false by that (hypothetical) losing trade.

Some turtle traders use an alternative method which involves taking all breakout trades even if the previous breakout trade lost or would have lost. But, for turtle trading personal accounts I have found that my drawdowns are less when adhering to the rule of only trading if the previous breakout trade was or would have been a loser.

Order size

When I receive an entry signal from a breakout, my mechanical trading system automatically enters with an order size of 1 unit. The only exception is when, as mentioned above, I’m in a period of deeper-than-usual drawdown. In that case, I enter ½ unit size.

Next, if the price continues in the hoped-for direction, my system automatically adds to the position in increments of 1 unit at each additional ½ N price movement while the price continues in the desired direction.

The mechanical trading system keeps adding to my holding until the position limit is reached, say at 4N as discussed earlier. I prefer limit orders, although you can also program the system to favor market orders if you wish.

Here’s an example entry into Gold (GC) futures:

N = 12.50, and the long breakout is at $1310

I buy the first unit at 1310. I buy the second unit at the price [1310 + (½ x 12.50) = 1316.25] rounded to 1316.30.

Then, if the price move continues, I buy the third unit at [1316.30 + (½ x 12.50 = 1322.55] rounded to 1322.60.

Finally, if gold keeps advancing I buy the fourth, last unit at [1322.60 + (½ x 12.50) = 1328.85] rounded to 1328.90.

In this example the price progress continues in such a short time period that the N value hasn’t changed. In any event, it’s easy to program your mechanical trading system to keep track of everything on-the-fly, including changes in N, position sizes, and entry points.

Turtle trading stops

Turtle trading involves taking numerous small losses while waiting to catch the occasional long-term changes in trend which are big winners. Preserving equity is critically important.

My automatic turtle trading system helps my confidence and discipline by removing the emotional component of trading, so I’m automatically entered in the winners.

Stops are based on N values, and no single trade represents more than 2% risk to my account. The stops are set at 2N since each N of price movement equals 1% of my account equity.

So, for long positions I set the stop-loss at 2N below my actual entry point (order fill price), and for short positions the stop is at 2N above my entry point.

To balance the risk when I add additional units to a position which has been moving in the desired direction, I raise the stops for the previous entries by ½ N.

This usually means that I will place all my stops for the total position at 2 N from the unit which I added most recently. Yet, in case of gaps-on-open, or fast-moving markets, the stops will be different.

The advantages of using N-based stops are obvious – The stops are based on market volatility, which balances the risk across all my entry points.

Exiting a trade

Since turtle trading means I must suffer many small “strike-outs” to enjoy relatively few “home-runs,” I’m careful not to exit winning trades too early.

My mechanical trading system is programmed to exit at a 10-day low on my long entries, and at a 10-day high for short positions. If the 10-day threshold is breached, my system exits from the entire position.

The mechanical trading system helps overcome my greed and emotional tendency to close out a profitable trade too early. I exit using standard stop orders, and I don’t play any “wait and see” games…. I let my mechanical trading system make those decisions for me.

It can be gut-wrenching to watch my account fatten dramatically during a major market move with a winning trade, then give back significant “paper gains” before I’m stopped out. Still, my pet mechanical trading system works very well.

Turtle trading algorithms offer a quick way to build your own do-it-yourself mechanical trading system which is simple, easy-to-understand and effective.

If you have the discipline to keep your hands off and let your mechanical trading system do its job, turtle trading may be your best choice.

After all, turtles are slow, but they usually win the race……

How To Win With Mechanical Trading Systems

March 18, 2014 by Eddie Flower 13 Comments

Much ink has been devoted to pinpointing the causes of mechanical trading systems failures, especially after the fact. Although it may seem oxymoronic (or, to some traders, simply moronic), the main reason why these trading systems fail is because they rely too much on the hands-free, fire-and-forget nature of mechanical trading. Algorithms themselves lack the objective human oversight and intervention necessary to help systems evolve in step with changing market conditions.

Mechanical trading systems failure, or trader failure?

Instead of bemoaning a trading-system failure, it’s more constructive to consider the ways in which traders can have the best of both worlds: That is, traders can enjoy the benefits of algorithm-managed mechanical trading systems, such as rapid-fire automatic executions and emotion-free trading decisions, while still leveraging their innate human capacity for objective thinking about failure and success.

The most important element of any trader is the human capability to evolve. Traders can change and adapt their trading systems in order to continue winning before losses become financially or emotionally devastating.

Choose the right type and amount of market data for testing

Successful traders use a system of repetitive rules to harvest gains from short-term inefficiencies in the market. For small, independent traders in the big world of securities and derivatives trading, where spreads are thin and competition fierce, the best opportunities for gains come from spotting market inefficiencies based on simple, easy-to-quantify data, then taking action as quickly as possible.

When a trader develops and operates mechanical trading systems based on historical data, he or she is hoping for future gains based on the idea that current marketplace inefficiencies will continue. If a trader chooses the wrong data set or uses the wrong parameters to qualify the data, precious opportunities may be lost. At the same time, once the inefficiency detected in historical data no longer exists, then the trading system fails. The reasons why it vanished are unimportant to the mechanical trader. Only the results matter.

Pick the most pertinent data sets when choosing the data set from which to create and test mechanical trading systems. And, in order to test a sample large enough to confirm whether a trading rule works consistently under a wide range of market conditions, a trader must use the longest practical period of test data.

So, it seems appropriate to build mechanical trading systems based on both the longest-possible historical data set as well as the simplest set of design parameters. Robustness is generally considered the ability to withstand many types of market conditions. Robustness should be inherent in any system tested across a long time range of historical data and simple rules. Lengthy testing and basic rules should reflect the widest array of potential market conditions in the future.

All mechanical trading systems will eventually fail because historical data obviously does not contain all future events. Any system built on historical data will eventually encounter ahistorical conditions. Human insight and intervention prevents automated strategies from running off the rails. The folks at Knight Capital know something about live trading snafus.

Simplicity wins by its adaptability

Successful mechanical trading systems are like living, breathing organisms. The world’s geologic strata are filled with fossils of organisms which, although ideally suited for short-term success during their own historical periods, were too specialized for long-term survival and adaptation. Simple algorithmic mechanical trading systems with human guidance are best because they can undergo quick, easy evolution and adaptation to the changing conditions in the environment (read marketplace).

Simple trading rules reduce the potential impact of data-mining bias. Bias from data mining is problematic because it may overstate how well a historical rule will apply under future conditions, especially when mechanical trading systems are focused on short time frames. Simple and robust mechanical trading systems shouldn’t by affected by the time frames used for testing purposes. – The number of test points found within a given range of historical data should still be large enough to prove or disprove the validity of the trading rules being tested. Stated differently, simple, robust mechanical trading systems will outshine data-mining bias.

If a trader uses a system with simple design parameters, such as the QuantBar system, and tests it by using the longest appropriate historical time period, then the only other important tasks will be to stick to the discipline of trading the system and monitoring its results going forward. Observation enables evolution.

On the other hand, traders who use mechanical trading systems built from a complex set of multiple parameters run the risk of “pre-evolving” their systems into early extinction.

Build a robust system that leverages the best of mechanical trading, without falling prey to its weaknesses

It’s important not to confuse the robustness of mechanical trading systems with their adaptability. Systems developed based on a multitude of parameters led to winning trades during historical periods – and even during current observed periods – are often described as ‘robust.’ That is no a guarantee that such systems can be successfully tweaked once they have been trade past their “honeymoon period.” That is an initial trading period during which conditions happen to coincide with a certain historical period upon which the system was based.

Simple mechanical trading systems are easily adapted to new conditions, even when the root causes of marketplace change remain unclear, and complex systems fall short. When market conditions change, as they continually do, the trading systems which are most likely to continue to win are those which are simple and most-easily adaptable to new conditions; a truly robust system is one which has longevity above all.

Simple algorithmic mechanical trading systems with human guidance are best because they can undergo quick, easy evolution and adaptation to the changing conditions in the environment (read marketplace).

Unfortunately, after experiencing an initial period of gains when using overly-complex mechanical trading systems, many traders fall into the trap of attempting to tweak those systems back to success. The market’s unknown, yet changing, conditions may have already doomed that entire species of mechanical trading systems to extinction. Again, simplicity and adaptability to changing conditions offer the best hope for survival of any trading system.

Use an objective measurement to distinguish between success and failure

A trader’s most-common downfall is a psychological attachment to his or her trading system. When trading-system failures occur, it’s usually because traders have adopted a subjective rather than objective viewpoint, especially with regard to stop-losses during particular trades.

Human nature often drives a trader to develop an emotional attachment to a particular system, especially when the trader has invested a significant amount of time and money into mechanical trading systems with many complex parts which are difficult to understand. However, it’s critically important for a trader to step outside the system in order to consider it objectively.

In some cases, the trader becomes delusional about the expected success of a system, even to the point of continuing to trade an obviously-losing system far longer than a subjective analysis would have allowed. Or, after a period of fat wins, a trader may become “married” to a formerly-winning system even while its beauty fades under the pressure of losses. Worse, a trader may fall into the trap of selectively choosing the testing periods or statistical parameters for an already-losing system, in order to maintain false hope for the system’s continuing value.

An objective yardstick, such as using standard deviation methods to assess the probability of current failure, is the only winning method for determining whether mechanical trading systems have truly failed. Through an objective eye, it’s easy for a trader to quickly spot failure or potential failure in mechanical trading systems, and a simple system may be quickly and easily adapted to create a freshly-winning system once again.

Failure of mechanical trading systems is often quantified based on a comparison of the current losses when measured against the historical losses or drawdowns. Such an analysis may lead to a subjective, incorrect conclusion. Maximum drawdown is often used as the threshold metric by which a trader will abandon a system. Without considering the manner by which the system reached that drawdown level, or the length of time required to reach that level, a trader should not conclude that the system is a loser based on drawdown alone.

Standard deviation versus drawdown as a metric of failure

In fact, the best method to avoid discarding a winning system is to use an objective measurement standard to determine the current or recent distribution of returns from the system obtained while actually trading it. Compare that measurement against the historical distribution of returns calculated from back-testing, while assigning a fixed threshold value according to the certainty that the current “losing” distribution of mechanical trading systems is indeed beyond normal, to-be-expected losses, and should therefore be discarded as failed.

So, for example, assume that a trader ignores the current drawdown level which has signaled a problem and triggered his investigation. Instead, compare the current losing streak against the historical losses which would have occurred while trading that system during historical test periods. Depending upon how conservative a trader is, he or she may discover that the current or recent loss is beyond, say, the 95% certainty level implied by two standard deviations from the “normal” historical loss level. This would certainly be a strong statistical sign that the system is performing poorly, and has therefore failed. In contrast, a different trader with greater appetite for risk may objectively decide that three standard deviations from the norm (i.e. 99.7%) is the appropriate certainty level for judging a trading system as “failed.”

The most important factor for any trading systems’ success, whether manual or mechanical, is always the human decision-making ability. The value of good mechanical trading systems is that, like all good machines, they minimize human weaknesses and empower achievements far beyond those attainable through manual methods. Yet, when properly built, they still allow firm control according to the trader’s judgment and allow him or her to steer clear of obstacles and potential failures.

Although a trader can use math in the form of a statistical calculation of standard distribution to assess whether a loss is normal and acceptable according to historical records, he or she is still relying on human judgment instead of making purely-mechanical, math-based decisions based on algorithms alone.

Traders can enjoy the best of both worlds. The power of algorithms and mechanical trading minimizes the effects of human emotion and tardiness on order placement and execution, especially with regard to maintaining stop-loss discipline. It still uses the objective assessment of standard deviation in order to retain human control over the trading system.

Be prepared for change, and be prepared to change the trading system

Along with the objectivity to detect when mechanical trading systems change from winners into losers, a trader must also have the discipline and foresight to evolve and change the systems so they can continue to win during new market conditions. In any environment filled with change, the simpler the system, the quicker and easier its evolution will be. If a complex strategy fails, it may be easier to replace than to modify it, while some of the simplest and most-intuitive systems, such as the QuantBar system, are relatively easy to modify on-the-fly in order to adapt to future market conditions.

In summary, it can be said properly-built mechanical trading systems should be simple and adaptable, and tested according to the right type and amount of data so that they will be robust enough to produce gains under a wide variety of market conditions. And, a winning system must be judged by the appropriate metric of success. Instead of merely relying on algorithmic trading rules or maximum drawdown levels, any decision about whether a system has failed should be made according to the trader’s human judgment, and based on an assessment of the number of standard deviations of the system’s current performance when measured against its historic-test losses. If mechanical trading systems are failing to perform, the trader should make the necessary changes instead of clinging to a losing system.

Is Your Account Overleveraged?

March 7, 2014 by Kalen Smith Leave a Comment

Did your broker ever tell you that you can leverage your trade? Here is a quick primer if you aren’t familiar with the term.

Leverage (also called buying on margin) means that you can borrow funds to place your trades. For example, let’s assume that you have $500 in your account. You could borrow $4,500 from your broker to place a $5,000 trade. This means that your account would be leveraged 10:1.

Leverage can be a great way to increase your return. In this case, you would magnify your return 10 times over. The downside with leverage is that it also magnifies your losses proportionally as well.

Dangers of Overleveraging

You shouldn’t be afraid to buy on the margin for fear of making some bad trades. You will inevitably make some wrong trades with or without being leveraged. The problem is that taking on too much leverage can completely wipe you out. Here are some things that you need to keep in mind.

You May Face Margin Calls

You need to put aside enough money in your account to cover any losses that you incur. The money that you set aside to cover losses is known as the usable margin. Your broker will allow you to keep a trade open until the loss is equal to your usable balance margin.

This is a complex topic, so let me illustrate with an example. You opened an account with $1,000. You decide that you want to buy 10 mini lots (10,000 units) of the EUR/USD. You decide to use $500 to place a $100,000 trade by leveraging your account 200:1. This leaves you with a usable margin of $500.

Every pip is worth about $10, which means that even small fluctuations can have a substantial impact on your account. You will get a margin call as soon as it falls 50 pips below the purchase price. You would either need to increase the size of your usable margin or close the trade.

Why Margin Calls are a Concern?

As I stated earlier, your losses are significantly higher when your account is leveraged. Rather than losing $50, you will lose $1,000 if your account is leveraged 200:1. This can obviously cost you a lot of money if you made a bad trade.

However, being overleveraged can also cost you if you made the right trade. You may have accurately predicted that the currency would increase by 100 pips in the next 48 hours. However, the forex market is often very volatile. The price may drop by 50 pips before rebounding to the strike price. You would face a margin call and close your trade at a $500 loss before you got to realize your profit.

Placing a trade at a 200:1 margin would have been the wrong decision in this case. What would have happened if you leveraged your account 50:1 instead? Each pip would only be worth about $2.50. You would still have $375 in your usable margin if the price dropped by 50 pips, which means that you wouldn’t receive a margin call from your broker. By the time the price rebounds to 100 pips above the purchase price, you would have earned a profit of $250.

Your leverage ratio would have made the difference between a $250 profit and a $500 loss. It is important to keep that in mind when making a trade.

How Much Leverage Should You Use?

Everybody forex trader makes mistakes. You will become better at investing over time. However, you need to make sure that you don’t lose your shirt before you have a chance to learn the lessons. If you are a beginning forex investor, then you will probably want to use a much more conservative leverage ratio. Some investors recommend using a ratio of 3:1 or having no leverage at all.

Even seasoned traders need to be careful when making trades. Many aggressive traders use leverage ratios under 10:1. More cautious investors may use a leverage ratio of 3:1 or less.

Choosing a leverage ratio is a blend of art and science. Here are some things that you will want to keep in mind:

The market volatility. Prices can fluctuate much more significantly at some times than others. The average daily movement for the EUR/USD was 185 pips in 2008, compared to 110 pips in 2013. You can face a margin call much more quickly in a volatile market, so a lower leverage ratio would be smarter.
Correlation between currency pairs. Prices can vary considerably between different currency pairs. Average movement between the EUR/USD last year was 110 pips, while the GBP/JPY was 189. You would probably want to use a lower leverage ratio if you were trading the second pair.
Duration of your strategy. You will need to consider how long it will take to execute your trade. You may plan to keep your trade open for three days. It may be a good idea to set your usable margin so that you could incur an “average” loss for at least two of those days. If the average pip movement for your currency pair in the current market seems to 150 pips then you may want to make sure that your usable margin can cover a 300 pip drop. You may want to be even more conservative if the market is starting to become even more volatile.

Shaun also prepared a great video showing how the risk of any given trade affects a trader’s chances of blowing up.

There are a lot of factors to keep in mind when you are setting a forex margin. You will need to keep these in mind and decide how much risk you can take. Successful forex traders often leverage their investments, but they know how to do so wisely.