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The Worst Mistake in Trading
So you a got a great setup going. You are banking pips each and every day. You decide to drop more money into your account, you increase frequency and … you lever up! Because it’s time to stop being a wussy! It’s time to make it rain!
I give you two, three days – a week at most – before your fantasies of “bricks on bricks on bricks” blow a hole through your account big enough to drive a double-wide through. You just made the worst mistake in trading – you forgot about the Hidden Risk Relationship.
In any financial transaction you can achieve leverage two ways. The more common way that most of us are familiar with, is to simply borrow against collateral. That’s what margin is and we are all aware of its dangers. At BK we have a saying 4X for forex. It’s a shorthand for the maximum amount of leverage you should employ on any trade. It may seem ridiculously conservative to most traders, but if you want to stay alive in this game for more than a month then using 4 times your account size is about all you should do.
But if you are day trading. And I mean really daytrading where you do 5 to 10 trades every single day then 4X for Forex is way to aggressive.
But let me explain to you why. It has to do with the 2nd way to achieve leverage which is through turnover. If you ever worked retail you are well familiar with both concepts. You could borrow lots of money and stock the store with many items. Or you can flip over your inventory three times per month like Zara and achieve amazing leverage on your capital.
So when you are daytrading 10 times a day you are effectively flipping over your inventory. A lot. Which actually means you should use LESS leverage rather than more. Let’s say you use our 4X for Forex formula and you trade 10 times per day. That’s effectively 40x lever factor as you flip over 4X your equity 10 times per day. Do you think there is a chance that in doing 5-15 trades per day you could lose 3 or even 4 times on some days? You bet. At even a 25 basis point stop you are now down 4% in just one day. Do that a couple of days in a week and suddenly you are down 10% without even trying.
There is another reason why high leverage and high frequency do not mix. Revenge trading. No matter how much you promise yourself you won’t do it. You will. You’ll hit a couple of bad trades in a row. You’ll get pissed, and you’ll want to “get it all back” in one fell swoop. But if you are already trading on leverage that means you will have to lever up 10x, 20x to make up that one trade that brings you back to even. That is prescription for disaster. On the other hand, if you are trading at no leverage, even a few revenge trades won’t hurt you too badly. Certainly they won’t damage you permanently.
So the Hidden Risk Relationship comes down to frequency versus leverage. The more you do of one, the less you do the other. There is good reason why HFT funds trade only a couple of hundred shares per position. They understand that that returns are a function of frequency not leverage. It’s time that retail traders learned that lesson as well.