Forex traders are risk takers. We accept the market risks in the hope of making a killing making a living from trading the markets.
Here I will discuss a case study on the consequences of leverage and the critical decision whether to “risk little or to risk the lot”. I will use the Forex markets for this case study. Similar concepts apply across other markets, but this particular concept works well with the foreign exchange markets due to their volatility. You may not agree with me with this case study and I reserve the right to change my position on this at anytime. Also, this is written for people with some experience in trading Forex.
After trading the Forex markets for a few years and a little reflection I came up with this thought: I can risk a little or risk a lot. You’ve got two choices and four outcomes. First you have the choice of either risking a little money or risking the lot. The secondary outcome for both cases is not your choice: it is up to the market to decide whether it shall go up or down.
Yes, so aren’t you stating the obvious? What’s the point?
The point is, your initial choice of the amount of leverage is critical in determining your success in trading the Forex market.
But Paul? How did you arrive to that conclusion? Bear with me and you’ll see.
In this case study we will use the AUD/USD (Australian and US Dollar) currency pair, assume we are trading a standard contract size where each contract is worth $100,000 and so 1 pip equates to US$10. So in this case study we will assume that we have a profit target of US$1000 for this particular trade.
How we make that amount of profit, and the amount of risk you take on board depends on your fundamental choice (of risking a little or a lot) as well as the volatility of the particular equity. For the Aussie and US currency pair, it is quite rare to see 100 pip movements per day, unlike currency pairs such as EUR/USD (Euro/US Dollar). Typically the Aussie moves around 20 to 50 pips a day. That is the amount of volatility we are playing with. So to be realistic about your profit , assuming you are day trading and perfect “market conditions” (the market is going the way you set your trade), you should only expect to make 20 to 40 pips a day (that is in optimal circumstances – remember this is only a case study after all).
So we want to make US$1000 in the Forex markets, trading the AUD/USD currency pair. How can we accomplish that?
Well if you choose to risk a little and trade three contracts, the Aussie will have to move 33 pips in your favour – down if you shorted the pair or up if you went long (33 pips * 3 contracts * $10 per pip = US$990; 3 contracts = $300,000). Now if you choose to risk a lot, say eight contracts, the Aussie would then have to move twelve pips in your favour (12 pips * 8 contracts * $10 per pip = US$1040; 8 contracts = $800,000).
Now, please don’t take the contract sizes to heart. I am just plucking numbers out of the air to make a point on how much Forex leverage you should consider whenever you place your Forex trade (Or any trading in any market).
Do you see the big picture?
You can risk a little and get a profit, but you can also risk a lot and get the same profit.
The Return On Investment (ROI) would be different on both – the ROI will be impressive if you chose to risk a little. But the question is – is an impressive looking ROI important? Will trading larger contracts safer? – Since you don’t have to wait around for a larger pip movement.
In my opinion, there is no correct answer here (like in most of trading), it is up to you as a trader to select the amount of risk (Depending on your risk appetite and risk management plan) you will take in every trade. This choice is a trade off, in some cases it may be wise to trade a little and wait for the big payoff. But in other market situations, the best trade maybe to risk a lot, wait for a “natural price fluctuation” (a small movement is price that seems to happen in the forex markets), to achieve the same amount of profit.
Good luck and don’t forget to always have a stop loss!