In my experience, over-leveraging is one of the least-understood concepts in FOREX. Ask any FOREX trader what leverage they trade at, and 9 times out of 10 the answer you will get is, “200:1” or whatever the set leverage in the account is. This is a fatal misunderstanding.
Dirk DuToit, in his wonderful e-book “Bird Watching in Lion Country”, distinguishes between “Account leverage” and what he calls “Real leverage”. “Account leverage” is the leverage which the broker gives you to trade with. “Real leverage” is the actual leverage being employed at any one time relative to your account size. To illustrate this distinction, let’s use a real-world example.
Let’s assume that you open an account with $100,000. The account leverage is set at 100:1. This means that for each $100,000 standard lot, the broker will remove $1000 of margin to hold that position. With $100,000 in margin at your disposal, you could theoretically open 100 standard lots at a time. If you took a position in the market with 10 standard lots ($100,000 x 10 = $1,000,000), what would be your “real leverage” be?
Most traders would say 200:1. In fact, the “Real leverage” is actually 10:1 in this example. Why? Because the trade size ($1,000,000) is 10 times the account size ($100,000). Understanding “real leverage” is key to a long investment career while trading on margin.
To further illustrate this, take a look at the following table. If the market were to move 1% (100 pips), your account would react in the following way based on your “real leverage”:
Real % Price Change Leverage In Market
% Price Change In Account
100:1 1% 100% 50:1 1% 50% 33:1 1% 33% 20:1 1% 20% 10:1 1% 10%
3:1 1% 3% 1:1 1% 1%In other words, if your real leverage was 50:1 (your position in dollars was
50x your account value), your account would fluctuate by 50% with just a
100 pip market move. As any FOREX trader will tell you, most any currency can move 100 pips at almost any time of day, yet most traders are not examining their “real leverage”. Real leverage is important because it creates the equity swings which are terrifically exciting when in your favour, and terrifically frightening when against you.
To further illustrate this point, take a look at this drawdown recovery table:
% Return On Remaining
Loss of Capital Capital Required To Get Back
To Break-even
10% 11%
20% 25%
30% 43%
40% 67%
50% 100%
60% 150%
70% 233%
80% 400%
90% 900%
So, using the previous example, if you suffered a 50% drawdown as a result of over-leveraging, you would have to double the remaining money in the account (100% return) just to get back to break-even! That is, without question, a difficult if not insurmountable task.
Over-leveraging is often confused with protection of capital. They are related but different. Capital is protected through the use of stop-losses. Over-leveraging multiplies the effect of drawdown when you “guess”
incorrectly.
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