Part II. Overleveraging and Transaction Costs

Overleveraging and Transaction Costs - Forex School

Commander in Pips: In second part of this chapter I would like to touch the theme of trading costs and overleveraging with some examples – just to show you how dangerous leverage is.

How leverage impacts on your transaction costs - Forex School

In the beginning just couple of words how leverage impacts on your transaction costs. Let’s assume that you trade EUR/USD and pay no fees and commission, except for the bid/ask spread. Let’s say that this spread is 2 pips, so when you open and then close your trade you have to pay 4 pips totally as your trading expenses. Here is information to think about:

Leverage	2xBid/Ask Spread, Relative to Your Position	Bid/Ask Spread Paid as a Part of Your Capital, %
1:1	4 pips = 0.0004	0.04%
1:2	4 pips*2 = 0.0008	0.08%
1:4	4 pips*4 = 0.0016	0.16%
1:8	4 pips*8 = 0.0032	0.32%
1:16	4 pips*16 = 0.0064	0.64%
1:40	4 pips*40 = 0.0160	1.60%
1:100	4 pips*100 = 0.04	4.00%
1:500	*4 pips500 = 0.2**	20.00%

Pipruit: Wow, so, if we will totally utilize 1:500 leverage that is commonly provided now by different brokers, the bid/ask spread will be 1/5 of my start up assets. Say, if my capital 10,000 USD, then the bid/ask spread at any trade with 1:500 leverage will cost 2,000 USD?

Commander in Pips: Absolutely. So you can see that “fiscal death” and “leverage underestimation” are the same.

But to give you just hard rocking foundation of that statement, let’s turn to some numerical examples. I know you like them, don't you?

Some examples

Commander in Pips: First, I would like to ask you create a table that shows how much your account value will change depending on price change %.

Pipruit: Well, I suppose we do not need even the table. For example, if leverage is 1:100, it means that if price will change for 1% our account value will change at 100%. That’s why it calls 1:100.

Commander in Pips: Right, I see you’ve really got it. And what about margin – can you tell the same, if you know margin, say, 5%?

Pipruit: Margin shows the change of price in percents that will lead to 100% change in account value if leverage is totally utilized. As you’ve said margin is 5% and we apply leverage totally to our account value, i.e. use total account value as margin, then price should change for 5% to force the change in account value at 100%.

Commander in Pips: That’s correct. I see that you probably do not need any examples, but we will show them anyway, just to point devastating power of leverage.

Let’s suppose that you’re newbie day trader and you apply just a 50 pip stop-loss in most of your trades. You’ve checked it by the market’s volatility and come to the conclusion that for intraday charts this stop is sufficient. You’ve opened mini account with 1000$.

TASK #1 – you have opened a couple of mini lots at EUR/USD with average stop at 35 pips. If your stop has been triggered by the price – what part of your assets you have lost?

Pipruit: Well, first we need to calculate the margin, I suppose:

- Two mini lots are 10,000x2 = 20,000. Hence my leverage is 1:20;

- 0.0035*20*100 = 7%!

What a surprise – I’ve lost 7% right at start-up trade, unbelievable. But this was just a bad day. Probably. I’m ready for a return match, but I want to not just return to breakeven, but also to make a profit. So, probably I need to enter with 4 mini lots now…

Commander in Pips: Right. Let’s see what will happen next…

TASK #2 – you have opened four mini lots at EUR/USD with an average stop at 30 pips. But you’ve missed the time of a big US GDP release, so your stop has been triggered on fake out. What part of your assets you have now lost?

Pipruit: My assets after first trade are 1000-70 = $930.

Leverage = 4*10,000/930~43:1;

Loss = 0.0030*43*100 = 13%

Account balance now is 1 000-70-120 = 810$

Commander in Pips: So, in two trades you’ve lost 1/5 of your total assets. If you remember our major approach is to not risk more than 1.5% in every trade. So, you should have lost just 3%, but instead you’ve lost 20%!

Again, you’re newbie day trader and you apply just a 50 pip stop-loss in most of your trades. You’ve checked it by the market’s volatility and come to the conclusion that for intraday charts this stop is sufficient. You’ve opened mini account with 1000$.

TASK #3 – you have decided that this was just a fake out and thought that maybe you have to place farther stops. So, you’ve entered with the same 4 mini lots, but with 70 pip stops. Right at this moment an ECB rate hike has happened and you have been stopped out…

Pipruit: Ok, ok -

Leverage = 4*10,000/810~50:1;

Loss = 0.0070*50*100 = 35%

Account balance now is 810-70-120-280 = 460$

TASK #4 – you see that the market probably is returning right back and on the ECB statement that was just short covering before the announcement. You think that this probably will be easy money, based on a 5-min Butterfly, you just need to increase lot size… When you’ve thought about your trading plan, that over half your account has totally vanished and that is not good, you start to think that you have no choice – double or nothing.

Pipruit: Yes, so – I intend to enter on 5 min chart with 10 lots – stop will be tight – 20 pips, since this is 5 min chart!

Commander in Pips: But this was not short covering….

Pipruit: Oh, no…

Leverage = 10*10,000/460 ~217:1

Commander in Pips: Price moves down for 15 pips, then turns up and move for 70 pips in your favor.

Pipruit: Finally, I’m returning in Big business and my profit is…

Commander in Pips: …not so fast, son. You’ve forgotten that your broker provides you with just 1:250 leverage. So, when you have opened 10 mini lots – how much free margin do you have?

Pipruit: 460 – 10*10,000/250 = 460-400 = $60.

Commander in Pips: But, as we’ve said, the market has moved against you first for 15 pips or 150$. It has not reached your stop loss, but you have another frustrating problem – what is it?

Pipruit: Margin call… After just 6 pips against me… 6 pips!

Commander in Pips: That’s the cost of overleveraging and underestimation of it. Also pay attention to how “trader’s sins” go side-by-side with destroying of your trading plan. First, you just entered with slightly greater lot, later you totally have broken all money management and in last trade you have absolutely denied and negated your entire trading plan per se.

Pipruit: Right, sir. But in reality I hope that I will not fall into this pit. I will try to be a disciplined and diligent trader.

Commander in Pips: You’re one of my best pipruits. I hope so that you will be fine. Finally, at the end of the current chapter let’s just point out important moments of leverage and how to deal with it.

1. You have to 100% understand how leverage impacts on your assets value. So, this will let you to choose – when to use it and when not;

2. Very often leverage just blows off trading accounts due light attitude to it or simply ignorance of it. It is worthwhile to say that this is typical not just for newbie traders but sometimes even experienced ones have fallen into such traps;

3. The more you’re leveraged the more you have to be careful and disciplined;

4. Brokers provide you with huge leverage, since their money comes from the bid/ask spread and very often your loss also. Hence the more often you trade with big leverage and/or big loses – all the better for them. But don’t give them a chance – try to ride leverage with no-leverage trading initially with profit. Later you will able to use greater leverage in your favor reasonably;

5. Leverage is not a case of “Whatever is not forbidden is permitted”;

6. Again, trading is a business – this is not a “how to be richer than Mr. Buffet in 5 days” journey. So, treat it correspondingly with solid respect;

7. Reasonable goal setting will help you to not become fascinated by leveraging.

Part II. Overleveraging and Transaction Costs

Comments

Table of Contents