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Forex Trading Strategy – Lever Up?
In FX where leverage is an astronomical 50:1, traders can effectively hold 50,000 units worth of currency against only $1,000 dollars worth of equity. On the surface this sounds like an attractive proposition but it is in fact a recipe for disaster. High leverage is exactly like high speed driving. The thrill is amazing, but just one tiny bump on the road will cause you to swerve and crash.
The underlying rule of trading is the higher the leverage, the smaller the margin for error. And since all of us are human, we are prone to errors constantly, which is why a trader who uses high leverage on a regular basis has almost no chance of surviving over the long run. One of the most insidious aspects of high leverage is that it forces a trader to hold very tight stops in order control risk.
But the tighter the stop, the stronger the chance of a stop out.
The reason for this dynamic is twofold. First, markets very rarely move in a straight line spending most of their time filling back and forth which almost assures that prices will retrace and nick you out of you position if your stop is small. Secondly, the spread based nature of the FX market turns tight stops into a sucker bet for the average trader.
On a typical EUR/USD trade with a 2 point spread, a 10 point stop and a 10 point target the actual odds require the price to move 12 points in the traders direction before reaching his target but only 8 points against him to stop him out. That’s a 40%-60% proposition on an even money trade. To give you an idea of how unfavorable that is the odds on roulette are only 49%-51% against the player and yet casinos are more than happy to ply you with free booze and amenities and let you play that game.
Trading massive size on a tiny slice of equity is not the only way to achieve leverage when you trade. Leverage can also obtained through turnover. Imagine that EUR/USD range trades between 1.3975 and 1.4000 for most of the European session. If you sell at the top of the range and buy at the bottom 5 times in a row using only 1 standard lot contract by the end of the day you will have made as much money as having traded one half a million unit position.
Levering through turnover is much better than levering through size. By using much smaller positions you have the ability to set wider stops and targets allowing you to remain in trades much longer and absorb losses with psychological and financial ease. And finally trading on low leverage and high turnover is how most professionals run their books, so that is perhaps the best reason to implement this strategy.