I could go on letting you believe that your retail foreign exchange (Forex) broker is on your side. While I’m at it, I might as well let you believe that every infomercial salesman is out for your best interests too. The truth is your friends are not always who they say they are and not everyone you trust is going to be there to look out for you, least of all the typical broker in today’s retail currency trading industry. If you trade Forex, you’re in the largest hunting grounds of the financial markets — and in this worldwide dog-eat-dog multi-trillion dollar jungle, you trade reality so get used to facing it. On the other hand, sometimes what others believe are the worst things in the world can be used to your advantage.
Read the service agreements and contracts. When a Forex broker says that they are a counter-party to your trades, and they’ve given themselves the choice whether or not to hedge your positions, what that means is that unless they choose to take action they generally win when you lose and vice versa. Under some situations, they net all their customer positions and take a trade with a tier 2 bank (their liquidity provider) to flatten their own net exposure. In most cases, however, they can actually maximize their profits by simply not doing this because the majority of their customers are consistently-losing gamblers who blow their entire accounts and might even re-deposit a few times to repeat the pattern and increase their profits further.
Does that mean you should stop trading retail Forex? Not at all. If we gave up every time we found out something wasn’t ideal in the world, most of us probably would’ve stopped playing the game of life after kindergarten. Just be aware of the real structure behind what you’re doing because there are usually ways to turn some of the market’s attributes into an edge of your own.
In fact, when I began my career as a proprietary trader, I routed many of my orders through to the human NYSE market makers to save on ECN (electronic communications networks) fees, which are charged for removing liquidity. I did this knowing full well that the market makers played the opposite hand most of the time. That was fine because my trades never depended on their good will. Plus, when the market was slow, I could take quick profits by using the market maker’s moves to my advantage — I would then route a closing order through an ECN like Archepelago (now NYSE Arca) who would in turn pay me a rebate for adding liquidity to the market. Aside from any market profits in the trade, this gave me a small profit in the commission structure alone, since the ECN rebate was larger than the market maker’s fee. With large lot sizes, these rebates amounted to large bonuses simply for placing trades. (In the order that we did this, it was perfectly legal — and still is — even in such a heavily regulated market as the NYSE.) If the logic of this technique is going over your head, don’t sweat it. It’s not important for you because the equivalent situation would never happen in the retail Forex market anyway. Just take from it that, sometimes, you can make a good thing out of an apparently unfavorable situation through a little creative maneuvering.
In the retail Forex world, there’s a few unique advantages of its own for you, the individual trader.
The first is what I like to call the multiple account edge. There is absolutely no one stopping you from opening more than one account at different retail Forex brokers at the same time. In fact, if you had $20,000 US dollars to start, I would definitely not recommend depositing the entire sum at any one single broker. You could either spread the sum between different brokers and gain the advantage of being able to route your trades through multiple market makers (a common practice for institutional traders) or simply deposit only what is needed to cover margin and drawdowns and keep the rest in a safe, insured, interest-bearing account or money market fund.
Consider the fact that most brokers in this industry are offering ridiculous levels of leverage (500:1 is fairly common these days) and some of these brokers offer a “no negative balance guarantee”, meaning you can never owe more than the amount you deposit.
So, if you’re a smart trader who knows that you should risk 2% (at most) of your total trading capital on any given trade, then instead of maximizing your leverage, use it as a way to deposit less of your real capital into your account. That way, any trade would still work out to the same effect on your overall capital, yet a disastrous event against one of your positions can only wipe out a small portion of your real trading capital (it can only touch the portion you actually deposited, as opposed to your entire notional account) thanks to the broker’s policy against negative balances.
To help you understand how to go about doing this, here are some simple calculations for this method. Re-read it a few times and take notes if you have trouble understanding the logic of it on the first time through.
For beginners, having $20,000 start may sound a little out of your league but the same calculations work for any size of account since it’s based on percentages (and will, therefore, compound as you grow your money) so let’s assume you have a starting wad of $1000. Since micro and nano lots are offered by many of these brokers, it should work out just as well as for a trader with $20,000 to start.
For this example, we’ll go with 2% risk per trade, which is actually the higher end of per-trade risk among professionals. When you’ve built up a larger amount, you might even want to go down to 1% or even less. For now though, here’s the calculation:
$1000 x 0.02 = $20
$20 per trade is your amount to risk on each trade.
Now, for ease of calculation, let’s say your stop loss is 100 pips. Let’s find out how many dollars per pip you’re allowed to trade with:
$20 / 100 = $0.20
Okay, that’s $0.20 (20 cents) per pip.
In order to achieve the $0.20 per pip of market movement, you need to trade 2 micro lots (2000 units). If you’re wondering how you can determine this part as quickly as possible, always remember that 10,000 units (1 mini lot) is $1 per pip, so if you want $0.20 per pip:
10,000 units x 0.20 = 2000 units
You might have read that one “standard lot” is actually 100,000 units, or $10 per pip, which is the smallest size traded by the real interbank market participants. That’s true but mini lots (10,000 units) are the easiest way to calculate units from per pip values simply because it works out to $1 per pip. Just remember: 10,000 multiplied by the per pip value equals the desired number of units to trade. You can use it to multiply for larger sizes just as well.
Now, you want to find out how much margin needs to be deposited in order to trade 2000 units (2 micro lots) of base currency on a broker that offers 500:1 leverage.
500:1 (sometimes shown as 1:500 on some brokers’ advertising material) just means that for every dollar you deposit, you’re allowed to control 500 units of base currency. So, in order to reverse this logic, since you want to find out how much is needed in order to trade 2000 units, you divide the units by the leverage:
$2000 / 500 = $4
You read that right, you only need to deposit $4 to control 2000 units of base currency on one of these highly leveraged accounts. Of course, since you’re not one of those suckers who would get their entire account wiped out by one inevitable losing trade, you wouldn’t deposit just enough to cover margin because your trades need breathing room and draw-downs happen even for the best of traders. So let’s calculate how much more you need to deposit in order to cover a month-long draw-down period.
Assume that you may make one trade per day, and that there are approximately 24 trading days per month (on average, this should be fairly accurate). To be completely pessimistic, let’s prepare you for an insane losing streak that lasts for an entire month.
You were risking $20 per trade in this example, so let’s prepare you for 24 losing days in a row:
$20 x 24 = $480
That’s a total $480 of risk capital for a month with a $4 margin. Now add the margin requirement to the risk capital and you’ve got:
$480 + $4 = $484
There you have it. Less than half of your initial capital of $1000 needs to be deposited with your broker in order to trade safely. You can further optimize this strategy by choosing a broker with low or no fees for deposits and withdrawals. To take it a step further, you can even split the deposit in half and use two different brokers at once and split your trades, hedge fund trader style, if you’re paranoid about any shady dealer tricks from one of your brokers.
In this hypothetical situation, where your strategy requires only one trade per day, you’re actually prepared to lose every single day for an entire month. You might be thinking, “if I had that kind of losing streak, I might as well be taking the reverse of my own trades all the time and I’d be a winner.” Well, that’s not quite the point of this. In practice, you may trade more or less than what works out to one trade per day (some days offer more and others offer none, depending on your particular strategy.) Even if you don’t make 24 straight losing trades, it’s entirely possible for a beginner to be inaccurate — and lose discipline, causing haphazard trades — often enough to end up causing a draw-down that’s equivalent to 24 straight losses from the starting point. Trading opposite wouldn’t have helped much in these cases since they aren’t consistently mechanical methods of entry and exit.
The real purpose of the maximum draw-down deposit is to prepare you for the worst. It doesn’t matter how you get there, it just matters that it can happen and you’ll be ready for it.
The amounts you gain from trading these sizes may sound like pocket change, but it’s better to start off trading safely this way — and slowly building your capital and experience — than to try to gamble your way up recklessly from the beginning. By the time you’ve built a larger capital base, you will have gathered the experience to control larger amounts with less fear. It’s a win-win situation with your psychology, experience, and the actual size of capital that you’ll be controlling.
I know you’ve seen all the advertisements for contests where punters make 600% on their tiny initial deposits. Well, guess what? There’s also similar advertisements for lottery winners who turned their $5 ticket into a few million. Would you risk your life savings trying to duplicate that trade too? For every ten or twenty of those high-gaining punters, there are hundreds of customers losing their entire account balances every month trying to do the same thing on the same brokers. This is a game of survival, and you won’t survive if you blow your entire initial capital on idiotic gambles that line the pockets of your counter-party.
A life long stream of steady income adds up to much much more money than the glorified gambling profits that the contest winners get from using all of their leverage to the max. As your trading capital grows from consistent profits, your 2% of risk per trade will become larger and larger in dollar value, so if you keep this up, you’ll be well on your way to bigger trade sizes and, consequently, bigger gains per winning trade. This is the way to build your account like a professional.
Another advantage with the current retail broker landscape is the handling of spikes in the market. If you had a real position in the interbank market where a tier 1 bank took the other side of your order, and a sudden unfortunate 40-pip spike takes out your stop loss (rare but entirely possible even on the real market), the money you lost on the spike is gone for good. This happens when you place stop loss orders in a real market, there are situations that can cause your order to trigger far outside the market, and it’s perfectly legitimate, because stop losses are still orders to be filled.
In a retail broker, however, such a spike would likely be corrected by your broker after the fact and you will, more often than not, be refunded the loss since it was on their books anyway. There’s no guarantee that every broker would be willing to do this for you, but most of the larger and more reputable ones — or even the small upstarts that would like to protect their public image on the internet forums — would rather hand that quick profit back to you instead of pocketing a one-time quick buck in exchange for years of negative word-of-mouth (ie. loss of future potential customers.)
If a spike like this ever happens to you, contact your broker as soon as possible and get it fixed. Keep in mind that, under the new NFA regulations in the United States (as of this writing), the broker only has 15 minutes to modify closed trades so get this done quickly. If you’re using a broker that resides outside of the US, or is simply not regulated by the NFA, you’re in less of a rush but contact the broker to ask for the reversal anyway. If you’re using two accounts, your other broker’s charts can be used as a great piece of evidence in this situation. (For the most part, it’s a way of saying, if they don’t give you the refund, your screen-shot from the other broker can be posted on forums all over the internet.)
Always know, and control, your risk at any given time. Always trade with a plan and know your edge. There are countless ways to find an edge in this market, but I’ve given you an edge in a part of your money management that’s currently unique to this loosely-regulated retail Forex environment.
Most importantly, always be careful who you listen to. In fact, go ahead and take every word I’ve said here with a grain of salt too. Use your own sense of logic and experience to assess the information I’ve offered you here.
Also be careful of what you read on the internet forums. Most of the so-called traders giving their latest “systems” are just “system hoppers” who jump from one method to the next in search of that one, single, perfect method to win every time. That’s about as logical as a man trying to find a method that would make every woman he approaches say yes, or a woman looking for a piece of relationship advice in a magazine that will solve all of her marriage problems for the rest of her life. None of these things exist because life isn’t a puzzle with a single key to success.
Learn to deal with reality and master it. Make the most of the good parts, accept some of the horrible parts that you can’t change, and at least limit the impact of the negative parts as much as possible, sometimes even turning one or two of these into your own advantage. That’s the real secret to trading — and to life in general.