THE TRADING CENTER SIMPLE LEVERAGE FORMULA

“Building a simple Money Management system to trade derivatives”

Money management (MM) is everything when trading in modern financial markets. The trading strategy we apply must be in accordance with our individual risk profile and long-term goals. The way we manage our funds should always be oriented towards our current capabilities and our future needs.

The Dilemma when Using Trading Leverage

When a potentially profitable trade has been identified, a trader must decide the portion of his funds that he is willing to risk upon that trade. A critical decision, as large trade sizes can lead to great profits but also to great losses. As it has been mentioned in the past, trading leverage can be your best friend or your worst enemy.

 

The Leverage Formula

The following leverage formula aims to provide a simple framework of understanding the attractiveness of each trade, and therefore, choose respectively the ideal leverage ratio.

Here is the formula (it is briefly explained below):

◘ Optimal Leverage Formula= [ (P/L) * (1/Spread) * (R/2) ] %

Where: (P/L) = Profit to Loss Ratio

Spread the difference in pips between the bid/ask, and

(R) = Risk Tolerance (values 1-100)

 

An Analysis of All Leverage Variables

Here is an analysis of all important variables that are incorporated in our simple leverage formula.

1. The Leverage & the Spread

Generally speaking, the leverage must be opposite to the magnitude of the trading cost. Trading leverage does not leverage only trading funds, but it leverages also the trading cost. Thus, high leverage should not be used when trading assets offered in high spreads. Trading cost includes the spread charged by a broker, and sometimes it includes also trading commissions or even overnight swap charges. In order to make things easier we assume that all charges are incorporated into the spread paid.

■ Wide Spreads → Lower Leveraged Trades

■ Narrow Spreads → Higher Leveraged Trades

2. The Leverage & the Distance of the Stop-Loss

The distance between the current price and stop-loss determines to a high extent the rate of leverage that must be used. Generally speaking, the rate of leverage must be opposite to the distance between the current price and the stop-loss level.

■ Wide Distance between Current Price & Stop-Loss → Lower Leveraged Trades

■ Narrow Distance between Current Price & Stop-Loss → Higher Leveraged Trades

3. The Leverage & Profit/Loss Ratio

◘ Profit/Loss = Potential Winning (Pips) / Potential Loss (Pips)

The Profit/Loss Ratio is a very simple ratio that calculates the attractiveness of any given trade. The profit potential is the difference between the current price and the Take-Profit. The Loss potential is the difference between the current price and the Stop-Loss.

Generally speaking, the P/L ratio indicates profitable trading when it takes values above 2 (P/L>2).

■ Higher Profit/Loss Ratio → Higher Leveraged Trades

■ Lower Profit/Loss Ratio → Lower Leveraged Trades

4. The Leverage & Risk Tolerance

The risk tolerance should take into account the needs, expectations, experience, and past performance of each trader. In another approach, the risk tolerance may reflect the past performance of a specific asset category or even the past performance of individual trading assets. For example, a Forex Trader when trading EURUSD has an accumulated past performance of +30 pips on average while when trading USDJPY has an average past performance of -10 pips. It is obvious how the past performance of each individual asset can and should influence the risk tolerance of each future trade.

■ Positive Past Performance → Higher Leveraged Trade

■ Negative Past Performance → Lower Leveraged Trade

 

 

Basic Principles Regarding the Right Rate of Leverage

By taking into consideration all the above factors we may conclude to some basic principles regarding the optimal Leverage Rate. Trading Leverage is balanced and optimized according to:

1 → The Spread Charged (the higher the Spread the less Leverage)

2 → The Nearest Key Support Level (the closest the Support-Level the more Leverage)

3 → The Nearest Key Resistance Level (the closest the Resistance Level the less Leverage)

4 → The Profit/Loss Ratio of the Trade (the higher the P/L the more Leverage)

5 → The Past Average Performance of Assets and/or Asset Classes (The better the Past Performance the more Leverage)

Formulating the above assumptions

By combining all the above assumptions we may conclude with the following formula.

◘ Leverage Formula: Optimal Leverage Rate = [ (P/L) * (1/Spread) * (R/2) ] %

 

This is an easy way to calculate the optimal/maximum trading leverage level for every trade.

 

Educational Examples Using the Leverage Formula

Here are some examples for educational purposes.

Assumptions:

1. Risk acceptance is high (R=50)
2. All charges are incorporated in the spread paid

Examples:

-if P/L=3 (which is good) and Spread=0.5pip (good too), then the formula indicates (max) leverage up to 150:1 (Indicates a very good trade).

{(3)*(1/0.5)*(50/2}}%=150%

-In another example, if P/L=1.5 and the spread=2pip, the formula indicates (max) leverage about 19:1 (Indicates not a good trade).

{(1.5)*(1/2)*(50/2)}%=18.75%

-In another example, if P/L=0.8 and the spread=8pip without commissions, the formula indicates (max) leverage 2.5:1 (That means better don’t even execute that trade).

{(0.8)*(1/8)*(50/2)}%=2.5%

 

Conclusions

As concerns the leverage formula, there are many more parameters that can be used and focus on the special nature of each trading asset. For day-traders that need to make decisions in a few seconds, this formula may prove useful. In addition, developers of automated trading applications may use this formula to filter the structure of their trading decisions and therefore optimize their performance.

Trading leverage can be your best friend but most of the time it is your worst enemy. That is why professional traders use tight trading leverage. The trading leverage increases not just your trading risk but also your trading cost. Never forget about the trading cost.

 

■ Formulating the Optimal Leverage Rate -The Leverage Formula

Giorgos Protonotarios, Financial Analyst, for Trading Center (c), 29th of June 2013