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As retail traders of margined products, we all face the same dilemma. We want to make money but realize that leverage will inevitably wipe out our capital in the end.
When I was at FXCM we used to run the “King of the Mini” contests every month. Every month some guy would turn 5,000 bucks into $25,000 and bask in the glory of recognition.
Yet throughout all those years, all those months of contests all those great attempts at making big returns, not one winner ever repeated his feat.
The reason, of course, is that most of the winners were the classic “have-a-hunch-bet-a-bunch” traders who caught a big move in some highly trending pair and just kept adding to their position. It didn’t hurt that in those days volatility was three times greater and you often saw 500 -- 800 point moves in a month.
Yet even guys who traded systematically could never repeat their winning ways because leverage always tripped them up. Remember that leverage is the true bet in the currency market. Dealers aren’t betting against your analytical skills to read the market or your facility with execution. They don’t have to. They bet that the law of large numbers will always wipe you out through leverage.
Just like dealers in Vegas couldn’t care less about your next roll of the dice or for that matter your next hundred rolls -- all of which you may win -- so too FX dealers could care less about your next trade or your next hundred trades. Both businesses are betting on the asymmetry of the odds in their favor. In Vegas, it’s the closed nature of the games that always makes the house a winner over the long run. That’s why casinos are more than happy to ply you with free drinks and keep you at the tables for as long as they can. The longer you stay at the dealing table, the higher their chances of emptying out your pockets.
Fortunately for us, the markets are not fixed outcome bets with guaranteed payouts to the dealers, but here the dealers are making a very different bet. In levered markets they simply have to bet that you will trade too large just once and that will be enough to wipe out all your prior wins and then some guaranteeing them a profit. And of course, you will. Because no one is 100% accurate ever.
If you trade at 100:1 leverage your chance of survival is 1%. At 400:1 leverage its 25 basis points at best. Put another way your chance of failure at 400:1 leverage is 99.75%. Although this is not really true mathematically, it’s close enough to the actual truth that you should use those numbers as mental shortcuts to assess your chances of success.
So given the crushing nature of leverage is there ever a way to make big money from small accounts?
They say that diversification is the only free lunch on Wall Street so here is an idea.
Diversify both by strategy and product. This Saturday I am teaching a webinar on every BK strategy I ever created. Going back through the strategies in preparation for the show I was shocked to see how many of them were still working well. Their edges weren’t fantastic (on average each strategy was basically banking 200-300 pips a year), but as Senator Dirksen once remarked, “A billion here, a billion there and pretty soon you are talking real money.”
So idea one is to create a separate brokerage account for each strategy. But don’t stop there. Create a separate account for each FX pair per each strategy so that you can sandbox risk as much as possible.
We know that in FX the same strategies could have wildly different results on different pairs. What works on GBPUSD may not work on AUDUSD and crosses are a whole separate issue altogether. So to protect yourself from the idiosyncratic risk of one bad trade blowing up your whole account here is the full idea.
Say you have $10,000 or risk capital. DON’T put it in one account. Create 10 separate trading accounts of $1,000 each. Say you have 3 good strategies to trade. Trade one strategy and one pair per account. So, account 1 has Strategy 1 EURUSD, account 2 has Strategy 2 EURUSD so on and so forth. At the end, you have 9 accounts that are trading 3 strategies on EURUSD GBPUSD and USDJPY the last account is just a cash reserve account. You trade your ideas on 10:1 maximum leverage (because that is the maximum I believe you can ever get away with).
Here is what will happen. One of your accounts WILL BLOW UP. But that’s a good thing. All the damage will be isolated to just that $1000.00 of capital. This is really good news both financially and psychologically. The broker’s margin call software will instantly liquidate you, effectively providing the stop that you are either mentally unwilling or technologically unable to take yourself.
But there is a much bigger psychological value to creating this structure. Every single blow up I’ve seen starts with a refusal to recognize a loss. The more money you have in the account the easier it is to let the loss float and fester like an infected wound until amputation is basically your only choice. Segregating your funds this way makes it much easier to get rid of bad trades. Physiologically blowing up a $1000 account is much easier than taking a $1000 loss in a $10,000 account -- and since you have no say in the matter anyway -- the hard decision is made for you. In the meantime, the accounts that are working could be doubling your money in year’s time -- turning you into The King of the Mini.