Forexunderstanding

How To Prosper At Forex Trading Leverage & The K-Factor

One of the big reasons that forex trading is an entirely different animal than stock trading or futures trading is leverage. Forex trading leverage can be enormous, as high as 400:1, and in most cases you get to choose the amount of leverage or gearing you want to trade with.

Super high leverage is a selling point for many online forex brokers. How many times have you seen the tout control 100,000 of euro for 250? Those numbers are correct, and, yes, the profit potential of super high leverage is compelling.

This article neither encourages nor discourages forex trading at super high leverage. Thats a personal decision, but a decision that can only be made sensibly with a professional understanding of all the implications of leverage and what they mean to your chances of prospering at forex trading. Its probably fair to say that unless you have a professional understanding of leverage that your chance of even surviving at forex trading is slim to none.

One of the fundamental terms of forex trading is PIP. You will see that XYZ Broker charges 3 PIP per deal, or that the XY currency pair has an average daily range of 100 PIP. We all know that the value of a PIP is a variable that differs with each currency pair, but did you know that the value of a PIP also varies with the current price of the base currency, and with the gearing on your account?

For example, with EURUSD at 1.2723 and leverage at 100:1 the amount of a PIP is 7.86. At 200:1 leverage the PIP value doubles to 15.72. For forex traders with different gearing a 100 PIP move means entirely different things to their account equity.

Heres a new way to look at leverage with the K Factor. The three most common leverage ratios available from online forex brokers are 50:1, 100:1 and 200:1. The K Factor for the 100:1 leverage ratio is 1. The K Factor for the leverage ratio of 50:1 is .50, and the K Factor for the leverage ratio of 200:1 is 2.

How can you use the K Factor?

There are three ways to use the K Factor. The first is using the K Factor to calculate the value of a PIP for the currency pair you are trading.

Since 100,000 individual currency units (usually pounds or euros) is the normal size of a single lot you can calculate the value of a PIP with this formula:

(100,000current price with no decimal) * K Factor = PIP

Heres an example: The EURUSD current price is 1.2723 and your leverage is 100:1. With these facts the formula is:

(10000012723) * 1 = 7.86.

The value of a PIP is 7.86. If your forex broker executes your trade at a spread of 4 PIPs you are paying 31.44 for executing the trade whatever euphemism the broker happens to be using for commission. If your leverage or gearing is 200:1 that execution will cost you 62.88.

The second way you can use PIP and the K Factor is to quickly determine the potential profit in a trade, or to know to a certainty the actual pound risk in a stop-loss setting.

For example, if you go long the EURUSD at 1.2723 and anticipate a move to 1.2850 what profit can you anticipate at 100:1 gearing?

12850 12723 = 127 PIP * 7.86 = 998.22 execution cost.

If you objectively set your stop loss at 1.2715 what amount are you risking in this trade?

12723 12715 = 8 PIP * 7.86 = 62.88 + execution cost.

The third way to use the K Factor is to avoid what the forex brokers call the safety net, and what I call kill but do not dismember.

Margin is not a down payment. Its cash-on-hand, your cash, that the broker uses to protect its own capital account from your mistakes. Thats all well and good because the global forex market will continue to work only if all participating brokers have adequate capital to meet their customers settlement obligations.

If losses from current open positions cause the equity in your account to fall below that required to maintain the total number of open positions, the brokers trading platform will immediately close all your open positions, even when the unrealized loss on any individual position is quite small. Your loss is the aggregate number of PIP per position * K Factor + execution costs. In almost every case thats just about everything in your account. This is the brokers safety net because you will not lose more cash than you had in your account (as can and does happen with commodities futures accounts.)

The formula is:

(Starting Balance Open Position Losses) ((1,000K Factor)* No. Open Positions) -1 < 10% = Kill But Do Not Dismember.

Most if not all broker platforms keep a running balance of your available margin to help you avoid this fatal situation. If you intend to trade multiple positions and fade into suspected price turning points you should consider setting up this formula in a spreadsheet so that you get an early warning long before the situation goes critical.

Mini accounts are based on 10,000 individual currency units with different margin requirements so make the necessary adjustment in the above formulas before doing the calculations

Back when I first started learning about investing, I decided to start from the beginning and read basic books on personal finance as well as guides for understanding all of the investment world in a nut shell. Most of these authors were very knowledgeable and informative, but their investment advice was far too conservative for my taste. They would literally write chapter after chapter talking about the differences between conservative investing, which according to them generally yields somewhere around 5% PA, as opposed to risky investing which usually meant a diversified stockmutual fund portfolio yielding (in my mind) only slightly higher averages. What kind of returns can you expect in the stock market? Well they say the market has gone up an average of 10% a year since Adam and Eve. Popular indexes like the DOW and the now more popular S&P500 have always, like real estate, gone up over time.

Now, these market averages are almost worshiped like golden calves. Repeatedly drilled into my brain was the concept that there were hundreds (if not thousands) of fund managers and other professionals out there with Harvard degrees, decades of experience, millions of pounds under management, and they were all spending 15 hours a day consuming every single bit of market information in the hopes of beating these golden calves by a few points.

What chance did I have? If Dr. Fund Guru Jr. who eats, sleeps, breathes the markets and has more credentials than I have individual hairs on my body cant consistently make 20% a year…well…forget it kid…your chances are slim to none. I guess Ill buy some shares of XYZ fund and accept the scraps off the table from the stock gurus.

NOT!

The foreign exchange market offers many benefits that the stock market does not have. Most of these have been beaten to death on various forums, blogs, articles, e-books, etc. However, its always good to reiterate the positive (my own personal reason is last):
- Forex offers unprecedented liquidity. With over two trillion pounds transacted per day on the market, it makes filling any buysell order virtually instant. That equates to less slippage and more profitability. Paper trading stocks vs actually trading stocks is very different, because orders may not be filled in a timely manner. The difference between trading a forex demo accout and an actual account is virtually nill.
- Forex is available 24 hours a day 5.5 days a week, as opposed to the daylight trading hours of the stock exchanges.
- Forex is uncontrollable by large entities. Large net worth individuals, banks and fund managers who throw their weight around in the stock market can often have huge effects on price action. Because of the immense volume of foreign currency traded per day, the market is unmoved by heavy hitters. Not even central banks can control the Forex market.
- Forex offers up to 200:1 leverage as opposed to 2:1 stock leverage.
- Forex has no restrictions for selling short, as opposed to the stock markets uptick rule
- Forex can actually be traded INSIDE of an IRA or Roth IRA account.
- Forex gains are taxed at the preferred 6040 rate, no matter what trading style you use (intra-day, swing, position) as opposed to the tax penalties for holding stocks for short periods of time.

The list does go on, but for me the biggest advantage is a psychological one. I know it probably sounds silly, but fear and intimidation can sometimes subconsciously defeat us before we even begin. I dont like the idea of having to live up to, and in a way, compete with professional managers who have more knowledge of the fundamentals of the markets than I ever will. Its almost as if Forex, in some way, levels the playing field. I dont have to psychologically compete against anyones idea of what kind of returns are acceptable and realistic and what kind of returns are pure fantasy. I only have to trade until I can find an acceptable reward to risk ratio, and consistent profitability thereof. The only one I compete against is myself.

-Joshua White
http:www.consistentforextrading.com