The ancient Greek mathematician, Archimedes, is famously quoted as
saying that if he were given a lever that was large enough, he could move the
Earth. So leverage is powerful. Foreign Exchange and other brokers use the
principle to allow their clients to trade with amounts that are many times the
value of what they have available in their accounts (known as equity). Typical
leverage ratios are 100:1, meaning that a person with €100,000 in their account
could, in theory, take on positions, or one single position, valued at €10
million.
In the event of the exchange rate moving in their favour, this would
mean that all profits would be multiplied by a factor of 100 over what they
would have been if no leverage was used.
To place such a trade would not be wise, however, because a move in the
opposite direction would mean losses that were 100 times the value of those with
1:1 leverage (no leverage at all). A relatively small move in the wrong
direction would then wipe out the account.
The ability to trade with many times account value is possible because
the broker, in effect, provides a loan. This is secured on the equity in the account,
or the amount that could be withdrawn in the event that all positions were to
be closed. Should equity looks like disappearing, because of the
unwise use of leverage, for example, the broker has the right to liquidate any
or all positions in order to protect his loan.
Leverage is used when OmiCronFX places a trade. However, the Value at Risk
(VaR) is at all times the focus of our calculations, and the leverage is only
required as an enabler. An example will illustrate the principle:
In the event that a view has been taken that the AUDUSD pair is about to
rise, we will carry out a calculation, based in part on the principles of the
Kelly Criterion, which will determine the value of the trade. Because our
account is in Euro and we need to buy Aussie dollars with US dollars, the first
thing that is determined is the amount we will put at risk, in Euro terms. This
will, typically, be 2% of equity, or €2000 on a €100k account. This is
converted into USD and a calculation is made to decide the size of the trade,
which takes into account the Buy price, the level of our Stop Loss order, which
we ALWAYS use, and the amount we want to put at risk. We do not have to do this
ourselves, as the Silver Trigger routine works it all out as a matter of course
at the time, interrogating the account on a real-time basis in order to
determine the amount of equity available. It also takes care of the conversions
between the account currency and the Base and Quote currencies in use for the
trade, in this example the AUD (Aussie dollar) and the USD.
When the calculation is made it will consist of dividing the proposed
Value at Risk (VaR), properly adjusted for conversions from the account
currency, by what we term the Reach, or the difference between the Buy price
(or Sell price in the case of a short trade) and the Stop Loss level. In a
typical trade this could result in the placing of an order to buy 250,000
Australian dollars. This amounts to leverage of approximately 2.5 : 1, which
represents prudent use of the facility when 100:1 is allowed by the broker.
The falling knife
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