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Lots, Leverage & Risk

  • #1
  • First Post: Mar 6, 2008 5:59pm Mar 6, 2008 5:59pm
What really equates to Risk when trading forex?

Is it Lots involved on a trade or is it the Leverage of the Account?

Many have argued about this for ages with plenty of heated arguments going left and right.

I would like to give some examples to show were the TRUE RISK is. In all examples below, Trader will have $10K of money to start trading.


Trader A opened a 500:1 Leverage Account with NorthFinance. He opened a Position SHORT 1 Lot GBPUSD @ 2.0000 with a 2.0100 StopLoss. GBPUSD eventually reached 2.0100 and he lost 100 pips. He lost $1K

Trader B opened a 100:1 Leverage Account with MBT. But since MBT offeres only 100:1, he thought his trade is 5 times less riskier than the NF Trader. So he opened a Position Short 5 Lots GBPUSD @ 2.0000 with a 2.0100 StopLoss. GBPUSD reached 2.0100 and he lost 100 pips. He lost $5K

Q: How did Trader B lost $5K or 5times more than Trader A when all the while, Lower Leverage means Lower Risk?

Most traders fail to understand the difference between True Leverage vs Account Leverage (or max leverage). In the above examples, Trader A has a 500:1 Account Leverage but was trading only 10:1 True Leverage. While Trader B has 100:1 Account Leverage but was trading with 50:1 True Leverage.

True Leverage is the ratio of your Open Trade and Account Balance. In the above examples:

Trader A has an Open Trade of 100K and a 10K Account Balance or 10:1 True Leverage.

Trader B has an Open Trade of 500K and a 10K Account Balance or 50:1 True Leverage.

This is why Trader B Lost 5 times more money than Trader A.

Do not mistake Account Leverage with True Risk. It is only the Maximum Risk factor and not necessary the actual Risk involved.

As an analogy, if your car has a max speedometer of 200 mph, that does not imply you are always driving at 200mph? And If you stick that 200mph Speedometer to your kiddie trike, does that imply your kid will be driving around the house at 200mph?

Get your Risk Factor Straight. Risk is Lot Size and not Account Leverage.
  • #2
  • Mar 6, 2008 6:04pm Mar 6, 2008 6:04pm
Lots = AccountBalance * Risk% / StopLossPips / PipValue
  • #3
  • Mar 6, 2008 6:10pm Mar 6, 2008 6:10pm
Quoting smjones
Lots = AccountBalance * Risk% / StopLossPips / PipValue
I assume you mean:
Lots = ( (AccountBalance * Risk%) / StopLossPips) / PipValue

Or equivalently:

Risk% = (Lots * StopLossPips * PipValue) / AccountBalance
Can anyone show where Leverage in this equation?

From smjones' equation, it is clear that RISK% is directly proportional to Lot size; the more lots on trade, the higher the risk involved. Risk% goes down if your AccountBalance is larger. But Risk in $$ will still be same whether you have $10K or $100K AccountBalance.
  • #4
  • Mar 6, 2008 7:03pm Mar 6, 2008 7:03pm
Quoting BurgerKing
I assume you mean:
Lots = ( (AccountBalance * Risk%) / StopLossPips) / PipValue

Or equivalently:

Risk% = (Lots * StopLossPips * PipValue) / AccountBalance
Can anyone show where Leverage in this equation?

From smjones' equation, it is clear that RISK% is directly proportional to Lot size; the more lots on trade, the higher the risk involved. Risk% goes down if your AccountBalance is larger. But Risk in $$ will still be same whether you have $10K or $100K AccountBalance.

This one topic I was looking for some clarification. Great to see this thread. thanks.

Now what is the impact of the margin required vs. the leverage.

Even if I play more lots knowing that my risk is directly proportional, the leverage restricts me in terms of how much I can trade given my capital, right?
Haste not to Enter AND Haste not to Exit !-TradeStar
  • #5
  • Mar 7, 2008 12:20am Mar 7, 2008 12:20am
Quoting BurgerKing
Q: How did Trader B lost $5K or 5times more than Trader A when all the while, Lower Leverage means Lower Risk?
Did I miss something elementary here?
Trader B Lost more, cause his position was 5x bigger.
Regardless of leverage.

Quote
Risk is Lot Size...
as with any "investment"

Carpe Divitiae
  • #6
  • Mar 7, 2008 12:33am Mar 7, 2008 12:33am
I would say that true risk is also closely related to stop size, although i dont think its a linear relationship.
  • #7
  • Mar 7, 2008 12:37am Mar 7, 2008 12:37am
Quoting Deadly Avenger
I would say that true risk is also closely related to stop size, although i dont think its a linear relationship.
Agreed, I should have added that to my post.
I would even go so far as to say, it's crucial, not just closely related.
Carpe Divitiae
  • #8
  • Mar 7, 2008 2:08am Mar 7, 2008 2:08am
Hi Burger

I think your analysis is spot on for a single trade. The brokers leverage, whether 400:1 or 50:1, nothing to do with risk, all it does is determine how much equity gets tied up to back the position.

Account leverage, taking position size in relation to equity, has little to do with a single trade, but what's important is the aggregate position of all trades. The more positions you have open, the higher your total risk (obvious I suppose), and the more likely you are to lose.

A broker who offers only 50:1 is helping you limit your trading, although that margin call is much nearer than with a 400:1 leverage so how much better off are you really?

What I get out of this, is that the real danger is not in how much broker leverage you have, but how close you are to a margin call, i.e. account leverage. If 70% of your account is tied up in backing positions you have a lot less room to move than if only 15% is tied up. It's a level of comfort thing I suppose. I like it low.

Anybody who gets a margin call (and who hasn't) has not been keeping an eye on their total exposure and was relying on hope to get them out of their predicament. A margin call is something you should spot miles away. If it happens twice, you should be doing something else.

There's two factors to keep an eye on - the risk associated with a single trade, and the total account risk. Those people pushing the limit are risking a lot more, even if the risk of individual trades may be pretty conservative.

Scenario:
$1000 account with 100:1 leverage
Trade risk = 2% = 20$.
You have 9 positions open @ 10 000$ each = 900$ tied up, so 100$ in free equity.

Fly this baby without stops and see if you can avoid the margin call


Quoting BurgerKing
What really equates to Risk when trading forex?

Is it Lots involved on a trade or is it the Leverage of the Account?

Many have argued about this for ages with plenty of heated arguments going left and right.

I would like to give some examples to show were the TRUE RISK is. In all examples below, Trader will have $10K of money to start trading.


Trader A opened a 500:1 Leverage Account with NorthFinance. He opened a Position SHORT 1 Lot GBPUSD @ 2.0000 with a 2.0100 StopLoss. GBPUSD eventually reached 2.0100 and he lost 100 pips. He lost $1K

Trader B opened a 100:1 Leverage Account with MBT. But since MBT offeres only 100:1, he thought his trade is 5 times less riskier than the NF Trader. So he opened a Position Short 5 Lots GBPUSD @ 2.0000 with a 2.0100 StopLoss. GBPUSD reached 2.0100 and he lost 100 pips. He lost $5K

Q: How did Trader B lost $5K or 5times more than Trader A when all the while, Lower Leverage means Lower Risk?

Most traders fail to understand the difference between True Leverage vs Account Leverage (or max leverage). In the above examples, Trader A has a 500:1 Account Leverage but was trading only 10:1 True Leverage. While Trader B has 100:1 Account Leverage but was trading with 50:1 True Leverage.

True Leverage is the ratio of your Open Trade and Account Balance. In the above examples:

Trader A has an Open Trade of 100K and a 10K Account Balance or 10:1 True Leverage.

Trader B has an Open Trade of 500K and a 10K Account Balance or 50:1 True Leverage.

This is why Trader B Lost 5 times more money than Trader A.

Do not mistake Account Leverage with True Risk. It is only the Maximum Risk factor and not necessary the actual Risk involved.

As an analogy, if your car has a max speedometer of 200 mph, that does not imply you are always driving at 200mph? And If you stick that 200mph Speedometer to your kiddie trike, does that imply your kid will be driving around the house at 200mph?

Get your Risk Factor Straight. Risk is Lot Size and not Account Leverage.
  • #9
  • Mar 7, 2008 6:51am Mar 7, 2008 6:51am
Quoting BurgerKing
I assume you mean:
Lots = ( (AccountBalance * Risk%) / StopLossPips) / PipValue

Or equivalently:

Risk% = (Lots * StopLossPips * PipValue) / AccountBalance

Can anyone show where Leverage in this equation?

From smjones' equation, it is clear that RISK% is directly proportional to Lot size; the more lots on trade, the higher the risk involved. Risk% goes down if your AccountBalance is larger. But Risk in $$ will still be same whether you have $10K or $100K AccountBalance.
Yes your precedence works the same. the parentheses do not change the order of operation in this case. But it does help to support your use of the distributive law
  • #10
  • Mar 7, 2008 7:27am Mar 7, 2008 7:27am
Quoting fsiltd
Did I miss something elementary here?
Trader B Lost more, cause his position was 5x bigger.
Regardless of leverage.
His position was 5x bigger on a same size account, therefore his LEVERAGE was 5x higher.

The maximum leverage offered by your broker should never even enter your mind. It is a completely irrelevant number.
  • #11
  • Mar 7, 2008 7:52am Mar 7, 2008 7:52am
Quoting fierceman
His position was 5x bigger on a same size account, therefore his LEVERAGE was 5x higher.

The maximum leverage offered by your broker should never even enter your mind. It is a completely irrelevant number.
That's my point.
And as BurgerKing said, lower leverage does NOT equal lower risk.

However, I don't quite follow the whole scenario.
The point, IMHO, would have been better made if they both opened a 1-lot trade, no?

Obviously, if they have the same entry, same stop, but ones in for 1-lot and ones in for 5-lots. One IS going to lose more than the other if stops get hit...regardless of leverage, whether "true" or "account" or "magic"...
He's position is 4-times bigger than the other trader.
Carpe Divitiae
  • #12
  • Mar 7, 2008 2:32pm Mar 7, 2008 2:32pm
Quoting fsiltd
Agreed, I should have added that to my post.
I would even go so far as to say, it's crucial, not just closely related.
Totally agree with you, I would say its both. Its closely related and its crucial. It also depends on the behaviour of the pair in question. I think that absolute risk is hard to quantify exactly outside of % of account risked per trade.
  • #13
  • Mar 7, 2008 2:45pm Mar 7, 2008 2:45pm
Quoting fierceman
The maximum leverage offered by your broker should never even enter your mind. It is a completely irrelevant number.
EXACTLY.

This is a strange thread frankly, if someone doesn't understand the concept of leverage and amount traded then he must either be less than a week into this on demo or got a BIG problem..

Simple, on E/U for example (the pip worth is a bit smaller for u/y g/y and a few other pairs and then there's E/G with twice larger pip worth as I recall):
leverage of 100 - 100 pips and you're done
lev. 50 - 200 pips till you're toast
lev. 25 - 400 pips of air
lev. 10 - 1,000 pips which you're sure will never go away...
lev. 5 - 2,000 pips to spare, go on vacation it'll take awhile to waste those unless they're on g/y or g/c
On the path to Enrichment.
  • #14
  • Mar 10, 2008 4:38am Mar 10, 2008 4:38am
Quoting Jurrasic
This is a strange thread frankly, if someone doesn't understand the concept of leverage and amount traded then he must either be less than a week into this on demo or got a BIG problem..
Indeed.
  • #15
  • Last Post: Mar 10, 2008 5:11am Mar 10, 2008 5:11am
Verry nice disscusion going on in here!

Only one thing I don't understand, everybody is talking about accountbalance.
But I believe the equity is the most important thing to watch.
Because that's the money that you will have if you stop trading and withdraw your funds.
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