Leverage as an Equalizer to Risk

Written by Team Strategist | 21 August 2009

In Foreign Currency Trading...

It is a given fact that there exist a considerable risk inherent in trading the "Foreign Exchange Market". As exchange rates increases, so does speculative capital do. The reason is that, as active prices move at a rapid pace,

most investments make more than a reasonable return than simply placing the funds in stocks and money market placements. That said, it takes the investor a shorter period of time in making the interest on the investment. Although, the risk is something that has been considered it is well worthwhile as compared to the slower pace of the stock market performance.

Leverage has indeed made its mark in almost all financial instruments. But the liquidity and flexibility that it offers the foreign currency trading could be enormous, that is when it is managed and properly executed. Being able to use the extra leverage in an investors account can be a cushion against any negative effects while in the market place. Hedging strategies can be applied with the leverage provided to absorb not only the directional price movement contrary to the position, but with the approprate leverage in a new position could build and add equity made on top of the investment capital from the leverage position.

This is a strategy where most traders apply whenever the market moves against their favor. Managing the risk is an art in itself, done by strategists who has been trading the FX market for some period of time. By building up additional equity on top of the initial investment, this enables the investor some breathing room that any future loss in the trade could be paid from the equity built and not from the main principal. Money management through proper fund allocation can play a vital role whenever a trade plan is developed even before entering this volatile market.

Hedging strategy is commonly applied whenever any trade position is affected negatively when the price action goes opposite to the existing position. And this happens most of the time especially when trading the foreign exchange market. Upon entry, the tendency of prices is to move against it making the trader doubt whether that position to buy or sell is correct. In most cases, traders need to consider breakeven points corresponding to the price. For there are spreads and commissions to be looked at even before such execution is made. The trading plan for scalpers or day traders so to speak, is to make between
10 - 50 pips in as much time allowed while being in the market. Although, one needs to consider if the trader is willing to take the gains in between those pip objective; how much would the trader be willing to tolerate a loss. If the tolerance point is also between 10 - 50 pips loss side, then ther is no rational or logical reason why such a trade should be made. It is considered to be a 50 - 50 chance basis. Rational and logical approach should always be present at all times while trading. The profit potential and objective should at least be three (3)X times as against a loss of one (1). This is self-explanatory.

But what if the prices went against the position right away. What happens then? As the trades are done and executed electronically through the trading platforms of the broker / dealers where the investor has the account opened; the normal procedure that a trader does is to place a stoploss order and a profit take order ahead of time. And there are several types of orders that can be place either an ( MIT ) market if touch, limit orders, which are good till closing sessions ( GTC ) or whichever comes first. As a word of caution, never give up the upper hand of decision making while trading this market.

However, the oders are only as good whenever a well develped trading plan takes place. In worst case scenarios, the extra leverage can be spread in contrary position of an existing trade sustaining a floating loss. In currency trading, when a trade is executed in a major pair such a GBP / USD, EUR / USD or AUD / USD as examples; in choosing the next currency pair to create a contrary position must be carefully studied and researched. Because, a poorly executed trade with a not so well chosen currency pair to match the existing one with may result to a wider spread in price change causing a bigger loss on both positions taken for the client / investor.

This is the most important thing to consider when choosing to hedge. It must be pointed out that the strategist must look for a pair where the directional movement of prices are a mirror image of the currency pair being traded. The movements made should always be compared with the trading range and the price changes with each other. For one currency pair may not necessarily follow the other at a given point of time. One of the best indicators would be the four (4) hour timeframe or intervals of each pair being compared. With a keen eye, this formations may well be identified easily specially for seasoned traders, but for the novice trader it may be difficult. Viewing the charts on several time frames may give the trader false signals detrimental to the strategy and may cause poor judgement in execution and choosing the right match. These for (4) hourly charts are best for entry and exist strategies. While the weekly can be used for the overall trading, positioning and trend analysis because of the reliability of information that it provides. Eliminating noises as most of our research team used to say is as important as reducing the glitches in the computer. As most traders use algorithmic formulas which have been quite popular nowadays in trading the retail forex industry.

Once the choice has been made amongst the other currency pairs such as the cross rates, forwards and currency options, then it is time to execute the plan of action and soften the ill effects of loosing in the market. As a matter of importance; do not forget to consider and pre-calculate the spreads on the current position and the matched pair, the amount of leverage exposure used for the trade, the average trading range; which is the high and low price, the net change in prices from closing to closing and above all is the net change in the overall equity change on the balance of the account from the current working price levels. Be sure to anticipate what the overall net effect would be if and when prices closed at such price levels.