Why less leverage can mean more trading profits - DailyFX Tips & Picks

TRADING financial markets is exciting for most people, particularly since most brokers offer high leverage and, with this leverage, even a small trader can generate a substantial gain. Yet this leverage can sometimes work to your disadvantage, leading to big losses very quickly.

This is because markets are often random in the very short term. Sterling-dollar, for example, can rise or fall a great deal in just a week. The current average weekly change for the last year is 1.2 per cent. This means that sterling-dollar can be up or down by 1.2 per cent on any given week.

Why do we focus on just one week? Because most FX traders will not hold a position for longer. We also know that the average trader with a small account tends to trade with an effective leverage of 26 times their equity. This means that the 1.2 per cent weekly change in sterling-dollar may translate into a 31 per cent gain or loss for the average trader. Clearly this is so risky that it can be considered to be gambling.

It’s risky because of the big swings and the randomness of markets. Prices can rise or fall on any single week, and this might be unrelated to the underlying fundamentals. A single week could make or break your trading account, so the trick is often to work with less leverage, and this is what we have seen clients with large accounts do.

They will usually restrict their effective leverage to five times their equity. By doing this, as a group, they have twice the number of profitable traders compared to the highly leveraged group.

For an in-depth look at these stats, see http://bit.ly/CityAM32

Alejandro Zambrano is a currency strategy analyst at DailyFX.com.