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Thursday, February 11, 2010

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!
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