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Formulating the Optimal Leverage Rate -The Leverage Formula

TRADING CENTER LEVERAGE FORMULA

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“Building a Simple Money Management System to Trade Derivatives & Forex”

Money Management is everything when Trading Derivatives. The way we manage our funds should always be oriented towards our current capabilities and our future expected needs. Any chosen trading strategy must be 100% compatible to the way we manage our trading funds. Our Trading Portfolio should be managed according to our individual risk profile but also according to our long-term goals.

The Dilemma when Using Trading Leverage

When a potential 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 is has be mentioned in the past, trading leverage is sometimes you best friend, and some other times your worst enemy.


The Leverage Formula

The leverage formula that is present in this analysis aims to provide a simple environment 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, and (R) = Risk Tolerance (values 1-100)

The Online Leverage Calculator

The following calculator is created by TradingCenter and it a simple model based on the leverage formula. This tool is provided for paradigmatic and self-training purposes.


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Created by TradingCenter.org


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 Rate of Leverage any trader uses must be opposite to the magnitude of his trading cost. The reason is that leverage does not leverages trading funds only but it leverages the trading cost too. So it is far better to use high leverage when narrow spreads are charged. Trading cost includes the spread charged by a broker, and sometimes it includes also trading commissions or even swap charges. In order to make things easier we assume that all charges are incorporated to the spread paid.

■ Wide Spread Charged → Low Leveraged Trade

■ Narrow Spread Charged → High Leveraged Trade

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

The distance between the stop-loss and the current price levels determines in a high extend the rate of leverage that must be used. Generally speaking the Rate of Leverage must be opposite to the distance between the current price level and the stop-loss level.

■ Wide Distance between Current Price Levels & Stop-Loss Levels → Low Leveraged Trade

■ Narrow Distance between Current Price Levels & Stop-Loss Levels → High Leveraged Trade

3. The Leverage & the Profit / Loss Ratio

Instead of using the distance between Support & Resistance the Profit/Loss Ratio may be used.

◘  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 formed between the current price levels and the Take-Profit Order. The Loss potential is formed between the current price levels and the placed Stop-Loss Order.

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

■ Higher Profit / Loss Ratio → High Leveraged Trade

■ Lower Profit / Loss Ratio → Low Leveraged Trade

4. The Leverage & the Risk Tolerance

The risk tolerance may be seen from a broad view and 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 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.

■ Higher Past Performance → High Leveraged Trade

■ Lower Past Performance → Low 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 Magnitude of the Spread Charged (the Larger the Spread the Less Leverage should be Used)

2→The Nearest Important Support Level (the Nearest the Support-Level the More Leverage should be Used)

3→The Nearest Important Resistance Level (the Nearest the Resistance Level the Less Leverage should be Used)

4→The Profit / Loss Ratio of the Trade (the Bigger P/L the More Leverage should be Used)

5→The Past Average Performance of Each Category Asset or of each Individual Asset (The Higher the Past Performance the More Leverage should be Used)

Formulating Leverage Correlations

By combining all the above mentioned correlations we may conclude to the following formula regarding the optimal rate of leverage that should be used.

Simple Leverage Formula:

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

R=Risk Tolerance,

High, R=100% | Medium, R=50% | Low, R=10%

This is an easy way to calculate the optimal / maximum leverage level that should be used each time. When P/L is high and the spread is low this ratio is maximized (and vice versa).

Examples using the Leverage Formula

Here are some examples when using this formula. We assume High Risk Acceptance in our examples and therefore we use R=50. We assume also that all charges are incorporated in the spread paid.

-For example if P/L=3 (which is good) and Spread=0.5pip without commissions (good too), then the formula indicates the optimal leverage ratio up to 150% (Indicates a Good Trade).

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

-In another example if P/L=1.5 (which is bad) and the spread=2pip without commissions, then the formula indicates the maximum leverage ratio up to 18.75% (Indicates a Bad Trade).

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

-In another example if P/L=0.8 and the spread=8pip without commissions, then the formula indicates the maximum leverage ratio up to 2.5% (That means don’t execute that trade).

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

Conclusion

There are many more parameters that can be used and focus on the special nature of each trading asset but for Day-Traders that need to make decisions in a few seconds this formula may prove really 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.

More Trading Research on Trading Center: » Trading Center Indicator (TCI) |» TCI+ Forex | » Identifying Investment Risk | » Identifying Charts Patterns | » Getting Started on Trading Center


■ Giorgos Protonotarios, Financial Analyst 

Formulating the Optimal Leverage Rate -The Leverage Formula

for Trading Center, 29th of June 2013

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