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Forex Trading: Controlling Leverage and Margin

Forex Trading: Controlling Leverage and Margin

2010-10-21 19:42:00
David Rodriguez, Head of Product
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Forex trading markets offer the lure of high leverage and potentially large gains, but leverage is always a double-edged sword and irresponsible use can lead to heavy losses. Recent changes in forex regulations have aimed to rein in market excesses. Regardless of maximum leverage regulations, however, traders should always manage individual use of margin responsibly and well within their capital limitations. This article will use a common forex strategy to show common pitfalls with excessive leverage.

Forex Trading Leverage with the Relative Strength Index (RSI) Trading Strategy

Using a very popular trading strategy, we hope to show the benefit of using low leverage ratios in a bid to maximize profits and protect trading capital. In an earlier article we discussed the strengths and weaknesses of the Relative Strength Index (RSI) trading strategy.

RSI Strategy

Basic Indicator

Relative Strength Index (RSI)

Buy Rule

Buy when 14-period RSI crosses below 30

Sell Rule

Sell when 14-period RSI crosses above 70

The backtested equity curve shown below displays the hypothetical results of the RSI strategy run on a 60-minute USDCHF chart going back to the beginning of 2009. We assume an account starting size of $10,000 and trade sizes of standard 100,000 lots on the USDCHF. This gives us leverage of exactly 10:1 at the outset of our trial period.

Hypothetical Equity of RSI Strategy on USDCHF 60-Minute Chart at 10x leverage 2009-Present

Forex Trading: Controlling Leverage and Margin

The strategy theoretically generated gains through this stretch, with a final profit of approximately $30,000 on an initial investment of $10,000. Yet we likewise see an important drawback of such a leveraged bet: some of the peak-to-trough drawdowns would have erased much of our gains and actually left us with negative equity. If we had invested in this strategy at the beginning of May, 2010, we would have seen a negative equity balance of over $4,000 on the subsequent drawdown.

Protecting against Large Losers

Trading without large losses would allow us to leverage our accounts as high as we would like without fear of total capital loss. Of course, what sounds too good to be true most often is. The following chart shows that 10:1 leverage would have completely wiped out our account in under two months of trading.

RSI Strategy on USDCHF 60-Minute Chart 10x leverage, May – Present

Negative equity

Forex Trading: Controlling Leverage and Margin

Hypothetical results show that the strategy had generated profits previously. Though past performance is never a guarantee of future results, fairly recent gains suggest that the strategy may work in the future. Yet we need to be prepared for fairly large drawdowns and plan our trading accordingly.

If we go back to our hypothetical strategy results, a leverage ratio of 5:1 would have protected against total capital loss but theoretically left us with healthy profits over the preceding year:

RSI Strategy on USDCHF 60-Minute Chart 5x leverage, May – Present

Forex Trading: Controlling Leverage and Margin

Trading with Lower Leverage

Past performance is never a guarantee of future results, but our simple example shows why we always advocate traders operate with low leverage in a bid to preserve capital.

Going back to our RSI strategy, leverage of 5:1 would have obviously resulted in smaller gains over our testing period. Yet the strategy finishes with respectable hypothetical gains, and even the worst drawdown through this stretch would not have wiped out our equity.

Hypothetical Equity of RSI Strategy on USDCHF 60-Minute Chart at 5x leverage 2009-Present

Forex Trading: Controlling Leverage and Margin

We could have obviously generated any number of strategies to fit the theoretical backtest results with commensurate drawdowns. Yet the results would have likely been similar, and the takeaway would stay the same. Cutting your maximum leverage in half—much as the CFTC’s recent rules have done—may not be a bad thing. In fact, halving leverage may make the difference between surviving a drawdown and losing 100% of your trading capital.

Next: Trading Commodity Correlations (30 of 50)

Previous: Trading Trends with Fibonacci

Written by David Rodríguez, Quantitative Strategist for DailyFX.com

To be added to this author’s distribution list, e-mail drodriguez@dailyfx.com with the subject line “Distribution List”.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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