Understanding leverage

Discussion in 'Forex' started by G-Boa, Jan 31, 2008.

  1. G-Boa



    Rookie question for the traders in the currency futures arena:

    Can anyone refer me to some good work papers I can use to do the math required to figure out the role leverage plays in trading currency futures contracts??

    I would really like some feedback from the guys who have worked through it and understand the vital role in leveraging your cash and how to protect yourself and to what degrees you are able to protect yourself. e.g. put on a leveraged trade and to what degree that trade can go against you before you are wiped out.

    I'm trying to calculate the degrees of risk and how rapidly it can accelerate against you....so I can put in measures to prevent being wiped out.
  2. I researched this some years ago. A leverage factor of 7 seemed optimal (in average market conditions, maybe 30-40% of your capital used as leverage). That was a relatively optimal tradeoff of putting your capital to work vs. risk exposure.

    Unfortunately, some yahoo who is running his forex at 40:1 may tell you to "wing it and max your leverage" based on opinion, but, that is my take.

    A person who studies the issues and votes carefully is often neutralized by someone who votes because the candidate has the same last name as their great great grandmother...
  3. PolarTim


    Ralph Vince wrote a couple books, "Portfolio Management Formulas" and "The Mathematics of Money Management" that discuss in great detail how much capital you should allocate to each trade, the likely size of drawdowns and your risk of ruin. The second incorporates most of what's found in the first, in summarized form.

    The amount you should allocate per trade or per contract is a function of your positive mathematical expectation.

    Are you asking about predicting future volatility? Imagine being long British Pound futures when George Soros went after that currency in the early 1990s. That type of event wipes out people who thought they understood risk.

    Long options might be worth considering instead of futures.

  4. I find trading simulation software to be useful for answering my questions about risk levels and leveraging. You might wish to take interest rates into account since currency positions may receive or pay substantial interest when leveraged.

    Your choice of risk levels, leverage, trading method and trading instruments likely depends on your own tolerance for losing streaks.
  5. G-Boa


    I believe, in the CME currency futures contracts (except the yen contract), that the leverage employed is 10:1.

    What I'm interested in finding out is: if I put up 1/10th my trading capital to initiate a position, how much "backup" capital do I need to cover that position to a certain, pre-determined degree???

    If there is a chepaer way to address that through an options on futures play, I will consider that too....but I'm a baby-step kinda guy ;)

    Haven't considered spot fx as a means - so the cowboys that use 100:1 etc likely have a different trading plan than mine.
  6. PolarTim


    Let's say you plan to hold trades for 10 days, on average. Go back through the price history and find every 10 day range from high to low. You could do this for 20 years. This assumes you're unfortunate enough to buy at the high or sell at the low, just to be safe.

    Range = HighestHighValueIn10Days - LowestLowValueIn10Days

    You could put these values in a spreadsheet. 95% of the values will be less than the largest 5% of the values. At that cutoff point, you know the point move and can multiply it by the tick value to get a dollar value of backup capital you'd need, in addition to at least the maintenance margin, so that you'd avoid a margin call. If you're more conservative you'd use the initial margin, not the maintenance margin.

    Then you could ask if there are likely to be larger moves in the future than the past 20 years?

  7. G-Boa


    Just bought "money management strategies for futures traders" - I think that will be able to help me figure the math.

    I don't suppose you have the playbook for George Soros's short GBP, do you??

    Seriously question tho, how did he approach that opportunity???

    BTW - not talking about predicting future volatility - more along the lines of establishing and maintaining a position - but, since volatility is inherent, wanna figure out where to draw the line to avoid ruin.
  8. Don't worry about leverage or trade managment to start. Just concentrate on entries and cutting down the heat you take.

    IB has a great simulator that you can practice on to work on your entries.

    Take 500 trades or so and see how you do.

    Once your entries are down then you can work on when to get out.

  9. PolarTim



    As I read it, the Pound declined to near the low of the range it was supposed to trade in with respect to the Deutschemark, while the US Dollar was also declining against the DM.

    It's easy for a central bank to weaken its own currency by printing money but to strengthen it they would need to expend foreign currency reserves or raise interest rates. They tried to raise rates but it wasn't enough and they declined in value vs. the DM, so speculators that sold GBP/DM could buy back at a lower level with their now stronger DM holdings.

    What didn't help was the German central bankers, who were very tough on inflation. They didn't want to weaken the DM and lower interest rates just to help the GBP and other EU central banks that didn't have their iron discipline.

  10. Most pros, real pros at investment funds; never use more than 10:1, why should you?

    In fact many use FX futures with additional cash, to reduce leverage.
    #10     Feb 1, 2008