Over trading - a strict NO NO

So you are an average retail trader with say, $4,000 as funds. Your broker is allowing you maximum leverage of 400:1.

You buy a standard lot of EUR/USD. At 400:1 leverage, your margin requirement is $250. Therefore, available margin = $4,000 - $250 = $3,750. It is also the same as maximum draw-down you can handle before getting a margin call.

Thus, maximum draw-down pips you can handle = $3,750/$100,000 = 0.0375 = 375 pips.

40 pips profit in this case means = (0.0040) * 100,000 * $1 = $400

Now, if you buy a mini lot: (grab a pen and paper and calculate by yourself before going further)

margin requirement = $10,000/400 = $25

available margin/maximum draw-down = $4,000 - $25 = $3,975

maximum draw-down pips = $3,975/$10,000 = 0.3975 = 3975 pips !!!

40 pips profit = (0.0040) * 10,000 * $1 = $40

Conclusion: Lower margin means you can handle more draw-down, but the trade-off is that your profit is lesser. Determine the lot size you are most comfortable to handle and the draw-down you are ready to risk.

Recommended Lot-size = Account value / (Drawdown in pips + 1/Leverage)

Most traders are comfortable with a draw-down of 500 pips. So for $4,000 account value,

recommended lot-size = $4,000 / (500pips + 1/400) = $4,000 / 0.0525 = ~75,000 (rounded down)

margin requirement = $75,000/400 = $187.50 < $200 (5% of $4,000)

Hence, 5% is a safe upper ceiling for margin requirement. Lower risk traders prefer 2%.

When using a lower leverage, say 100:1, as preferred by US brokers

recommended lot-size = $4,000 / (500pips + 1/100) = $4,000 / 0.06 = ~66,000 (rounded down)

margin requirement = $66,000/100 = $660 > $600 (15% of $4,000)

This is aggressive. You may prefer to stick to the 5% rule, in which case, recommended lot size = $200 * 100 = 20,000

Fund managers use 2:1 or 3:1 leverage at maximum. However, they have a portfolio of minimum $1,000,000 out of which they will risk 10% at maximum.

recommended lot-size = $100,000 / (500pips + 1/2) = $100,000 / 0.55 = ~180,000 (rounded down)

margin requirement = $180,000/2 = $90,000 = 9% of $1M. A fund manager may be aggressive at certain times and use a 10% margin. Or, he may be relaxed exposing only 2% to the market.

Using this simple tool and staying well below the recommended lot-size limit will definitely help you to prevent over-trading. Until your emotions and greed get the better of your trading instincts, that is!

Calculation of Profit and Loss

How do you calculate your profit, or loss? Yes, the platform provider will calculate it for you, but I am sure some of you are interested to know how the calculation is done! So here it is.

Profit/Loss = (SELL value - BUY value) * Contract size * Base currency unit

Base currency unit = Base currency conversion rate in $ (given your account is maintained in $)

First we will calculate on basis of 1 standard lot. 1 standard lot is a contract of 100,000 EUR/USD. The base unit is USD, so the equivalent is $100,000.

Profit: Buy EUR/USD at 1.3360. Sell at 1.3427. Base currency same as Account.

profit in pips = 1.3427 - 1.3360 = 0.0067 = 67 pips. (since pip = 1/10,000 = 0.0001 for base currency USD)

Profit = (1.3427 - 1.3360) * ($100,000) * $1 = $ 670.00

Loss: Sell GBP/JPY at 143.19. Buy at 144.42. Base currency different from Account.

loss in pips = 143.19 - 144.42 = -1.23 = 123 pips (since pip = 1/100 = 0.01 for base currency JPY)

Loss = (143.19 - 144.42) * ($100,000) * (JPYUSD contract value)

JPYUSD contract value will fluctuate throughout the day. Lets suppose USDJPY is 90.00

Therefore, Loss = (143.19 - 144.42) * ($100,000) * $(1/90.00) = -$1366.67

in case your account is maintained in EUR;

Loss = (143.19 - 144.42) * ($100,000) * (JPYEUR contract value) = (143.19 - 144.42) * ($100,000) * €(1/125.00) = - €984.00

Next, lets come to mini-lots. Contract value is 10,000 in this case.

You can figure out easily, the profit/loss is one-tenth of that calculated in the above cases.

To sum it up, your profit/loss is a direct multiple of your contract size and your profit/loss in pips. It is not dependent on your margin or the leverage you are using. When you have a position open with a floating loss, such a situation is called a "draw-down". Hence, you should have enough funds in your account to handle a draw-down and prevent a margin-call(same as in stocks and commodities). This is the primary reason - to prevent a margin call - why you should never risk more than 2-5% of your account funds as margin requirement. More on this later!

Basic terminologies and connotations of forex

In this post, we will look at the basic terms associated with forex and the minimum information you would need to understand any article in forex.

Leverage: It is the multiple by which the broker multiplies your investment on a particular contract. In stocks, we have been familiar with 2:1 leverage and maximum upto 10:1. The forex market allows you leverages of 100:1 and above! To some traders, this is insanity. However, higher leverage means you control a large contract with a relatively lesser sum of investment on your part.

For example, to buy a $100,000 contract of EURUSD, you would need $1000 at 100:1 leverage, and only $250 at 400:1 leverage! Determine which suits you better. Be informed though, that most successful traders keep their leverages lower than 10:1. Off course, they have larger portfolio than an average retail trader, which is approximately $5000.

Margin: The amount you need to deposit with the broker to control a contract. In the above example, if you are using 100:1 leverage, then your margin requirement is $1000. In case of 200:1, the margin requirement is... $500.

Spread: The brokerage in forex is termed as spread. Most brokers operate under the spread model now. The commission model is getting outdated as traders prefer the spread model now. The difference of spread from that in the stock market is that you have to pay fixed spreads in forex market. It is not like the brokerage in stocks where you have to pay a percent of your profit so it varies - the more you profit, the more is the brokerage. In forex, you can make this fixed spread thing work for you in a hedged trade.

Pip: No, this is not the guy from Charles Dickens' "Great Expectations". Pip is acronym for "percentage in points". It is the 1/10000th part of a forex contract, except those involving JPY, where it is 1/100th part.(because JPY hover around $100). In a trading day, the fluctuations happen in units of pips. However, nowadays you have 1/10th of a pip, so that the brokers can offer tighter spreads.

Steps To Success

That begs the question, how do you do it then? Here are the steps to success as a day trader as I see it.

1. Success at trading. Don't try to day trade until you've proven to yourself that you can trade successfully at a much slower pace.

2. Sufficient capital. If your trading account isn't in the high five figures, you shouldn't day trade (if that's going to be your only source of income).

3. A winning system. Day trading is harder than any other kind of trading that I know of. You really need to make sure your system will hold up. A system that works in a slower time frame will not necessarily work for day trading. Make sure you're system has a positive expectation.

4. Practice. Practice makes perfect. Yes, it's a tired old phrase, but it's true.

5. Patience. The market will try to destroy you as a new day trader. Have patience. Hang tough. You will make it, provided the previous four items are in order.

The correct education

If you are starting a new venture, no wonder you will like to have the right amount of education. Being prepared from beforehand is a sure way to crease out a lot of glitches that will eventually arise in your first days of trading. But the truth is, though there is a lot of material out there on the wire, very few of these really walk the talk.

Which should make you very cautious. If the dearth of education is one thing to be afraid of, to be trained with the wrong education is a bigger concern. It might be tougher to unlearn your initial lessons as you grow as a trader. But this is a part of the process. So don't hold on too tight on that strategy you began with. A better strategy should be out there, discovering which will make you a better trader.

Be a voracious reader. You will need to crunch a lot of data in the first few month to get into the grind. Weigh each bit of information and think of the exactly opposite. Hold a debate in your mind to realize the full potential and impact of that bit of info. A lot of portals exists to teach newbie traders. I will include some of them which I found useful in my initials days and I would recommend to a fellow trader.

98% failure rate

The hype of the failure rate has to addressed early.

I don't quite understand what feeds this hype. The truth is that with any business, a lot of new ventures are bound to fail. Whichever field you may be active or employed in, I am sure you can recount 10 businesses or people who failed for every one that succeeded. In fact, 95% of all registered companies get dissolved within 3 years. Forex trading is also a business, an enterprise. The reason why it is also subject to this failure rate.

Another belief that is completely personal to me is that 98% of people end up being in a field which is not their chosen best. How can they succeed if they are not in love with their work. Majority of the failed traders are people who came in to make a quick buck and move on to something else interesting to them. They add to the woes and the stats.

I don't want to say that these people will never be good at investment decisions. I would rather say that they should not be actively involved. We have a lot of other options to grow your wealth through regulated, managed funds. However, currency trading is something they should never try out first hand.

So decide if you have a belly for this sort of high risk investment. This decision will definitely make your next steps easier.

Taking the first baby steps ...

Though Forex has been around for 30 odd years, established after the abolition of the Gold Standard, it was not available to retail traders till off late. It was the battleground for corporate giants, banks, governments and large managed funds. Recently, those boundaries have been made off completely. So now, you and I can take part in the action and see where it can take us.

There is a lot of pessimism involved around anything dealing with forex. A lot of people have lost money and will keep losing. Because Forex Trading is a zero sum game, someone loses if someone has to win. This makes it edgier. Hence, it is always said that 98% of all forex traders are bound to fail!

To start with, I had to shave off this pessimism. Its not necessary that whatever you heard is true. The reason is a lot of people do it in their own ways and the results they get are for their own. It won't apply to you particularly. There's a huge amount of discipline and patience involved - which any successful trader would agree with - and these two qualities are not everybody's forte. So you need to determine if you have enough of these. And still greater is the control you need to put a leash on these two aspects.