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.