January 16, 2015

After SNB Chaos: A Good Time to Revisit Creative Leverage

Considering the events of this past week, with the Swiss National Bank (SNB) announcement wreaking havoc on the Forex markets - swiftly putting at least two of the largest retail FX brokers at risk of insolvency - many traders are naturally nervous about the safety of their own trading accounts.

Now is as good a time as any to revisit a very simple yet effective way to make use of the high leverage offered by Forex brokers... for safety rather than blind greed.

In an older post about money management and psychology, we introduced a way to make use of high leverage (low margin requirements) as a form of safety for traders: Only deposit an amount needed to trade the sizes you intend to trade, keep the rest safely in a savings account or money market fund.

When most trading educators and government regulators consider the advantages and risks of high leverage (like the 400 or even 1000-to-1 leverage offered by many offshore and early generation retail FX bucket shops) they only think in terms of its use at face value: to increase risk out of greed. And, in many cases, rightly so because the majority of beginners are more likely to misuse it that way.

However, for educated traders, risk is already a given regardless of leverage offered by the broker. Every professional trader has a solid method of trade sizing, either based on some form of tiered system or scaled to the size of the stop loss (sizing so that the average loss per trade works out to something like 2% of overall trading capital, for instance.)

For an educated trader, brokers offering ridiculous leverage amounts like 1000-to-1 won't change their trade sizes: It's still based on one of the above methods, or something similar.

What such leverage does allow is the freedom to do something that actually increases safety of funds: Deposit less of the total trading capital into each broker account. (And, as a result, leaving the rest in a safer place - an insured account for cash equivalents that pays interest.)

To illustrate this point, let's take a look at two hypothetical scenarios from the Swiss Franc (CHF) move on Black Thursday, January 15th 2015:

Scenario 1:

Trader A has $5000 of savings that he's willing to risk in Forex. He deposits the entire $5000 trading capital into an account at FXCM in the US, which offers a maximum of 50:1.

Of course, he's an educated trader so he won't blindly trade at 50x $5000 on every trade, that's simply the maximum offered. And 50:1 happens to be the maximum leverage allowed by a broker regulated in the US.

He's using a simple money management strategy: He'll risk 2% per trade, which works out to $100 at the moment. ($5000 x 0.02 = $100.) Now, he looks at the price action on the chart and determines that he wants to go long on the EUR/CHF with a 50 pip stop loss. He determines the size of his trade based on that (by dividing $100 by $50 and multiplying the result by the value per pip at the time -- this is why the leverage offered won't affect per-trade risk... but it's about to affect something else.)

For the sake of simplicity, let's say it works out to a nice round number for a trade size of 20,000 units (0.2 Standard Lots.) This, of course is far from even the maximum 50-to-1 leverage offered, it's only roughly four times the overall capital (give or take based on the current EUR/USD and USD/CHF rates)... but Trader A is an educated trader who sticks by his money management method.

As history would have it, that didn't even matter.

That was the morning the SNB announced the end of their EUR/CHF 1.2000 support. Boom! All hell broke loose, platforms froze, liquidity dried up, and to make a long story short... any way you cut it, with or without stop loss orders, the vast majority of Trader A's entire $5000 balance would've been wiped out.

Even if it hadn't been wiped out 100%, it was one hell of a steep drawdown that'll take years of trading safely to recoup... plus, the announcement of FXCM's close call with insolvency would've given Trade A a heart attack if this $5000 account was all the trading capital he had.

Scenario 2:

Trader B also started with $5000. However, rather than deposit the entire amount with any particular broker, whether they offer 50-to-1 or 1000-to-1, she's already aware of her average trade size due to the same 2% per trade method (for the sake of simplicity, we're choosing the old 2% method but this concept would work the same way for any money management strategy.)

As a result, Trader B only deposits $1000 with a broker. (Maybe even less if the broker offers higher leverage. Either way, it's enough to cover margin requirements and a bit more padding to take a couple of near-term drawdowns.)

The other $4000 stays in an interest-bearing Federally insured money market account.

Now, Trader B will make the same trade as Trader A. Same size, same pair, same time. The only difference is that she's making use of leverage creatively: using it for safety.

So when SNB drops Black Thursday on the Forex world and Trader A is experiencing a heart attack with his entire $5000 balance at stake (if FXCM hadn't been bailed out) Trader B knows that the most she'll lose is the $1000 in her broker account.

Sure, 20% is a hell of a drawdown if the worst case happens, but the other 80% is safe and collecting interest.

No matter how big your total trading capital may be, and no matter what your level of trading experience, a drawdown of 20% or less is still a far cry from a potential 100% loss on a single morning.

So the next time a politician argues for lowering maximum leverage and pretends it's for the safety of individual traders, remember that if FXCM were still allowed to offer 400-to-1 leverage, Trader B would be even safer: She could deposit about $150 and trade the same size while the broker's potential insolvency would only be putting that tiny percentage of her overall $5000 at risk.

Are we holding our breaths for an increase in leverage limits in the US or anywhere after this week? Of course not.

With every Black Swan event comes new bursts of media frenzy. Emotions run hot. Politicians will see opportunities to capitalize on posing as the good guy on the lookout for the little guy. It won't be long before the next debate arrives proposing even tighter limits on leverage.

Just remember: No matter how slick and convincing those arguments will be, creative use of leverage for educated traders will be at risk.

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