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Forex Trading Strategies – Why Leverage is Like a Drug
Drug dealers often use an insidious strategy to obtain new customers. They provide free samples of their wares to children in the form of a lollipop or candy bar. A few licks of the drug covered sweet and the kids are hooked, frequently for life. Speculative markets can operate much in the same manner except in finance the drug of choice is leverage.
How many times do we see advertisements on the web enticing traders with ridiculous leverage offers of 100:1, 200:1, 300:1 even 500:1? The lure is incredibly tempting -- turn $1000 into $100,000 within weeks! Take $10,000 and ride it to a million! Just like a drug high, a leverage high promises you perpetual bliss but in reality delivers mostly agony and pain. The truth of the matter is that in highly levered speculative markets it is far more common to see $100,000 accounts shrivel down to $1000 rather than the other way around.
Leverage just like drugs takes control out of your hands. The more leverage you use the more vulnerable you become. How many times have you been taken out of a trade that eventually recovered simply because you were over-leveraged? The margin call is the market’s secret weapon. It is the easiest way for the market to take away your money because it forces you to liquidate your position at the worst possible time, often at the absolute bottom if you are long or absolute top if you are short.
My trading improved astronomically when I drastically reduced my leverage. At present I trade FX the same way investors trade stocks with my positions never exceeding 50% margin or 2:1 leverage. For most FX traders that sounds laughably small, yet I am trading more than ever and enjoying my best month of performance in terms of return versus drawdown.
Reduced leverage is not the reason I am killing it in the market this month. My flow analysis has simply been much sharper and more on target. However, the fact that my analytics have been better this month has everything to do with my low leverage. By trading small I naturally execute my plan, taking stops quickly instead of letting losers run. Small stops are psychologically easier to accept and also a lot easier to recoup. By trading on almost no leverage I tend to trade much more professionally managing my risk without emotion since I am not vulnerable to a highly levered loss.
Just like a junkie who has kicked his habit and enjoys clean living, I have weaned myself off leverage. The net result is that both my mind and my trading account are much better off.