How To Prosper At Forex Trading – Leverage & K-Factor
One of the major reasons why forex trading is an entirely different animal than share trading or futures trading are gearing. Forex trading leverage can be enormous, as high as 400:1, and in most cases you get to choose the amount of leverage or gearing, you want to trade.
Super high leverage is a selling point for many online forex brokers. How many times have you seen tout "checking $ 100,000 euros for $ 250? These figures are correct and, yes, the profit potential of super-high leverage is convincing.
This article neither encourages or discourages forex trading on super high leverage. It is a personal decision but a decision can only be sensibly with a professional understanding of all the implications of leverage and what they mean for your chances for progress in forex trading. It is probably fair to say that unless you have a professional understanding of leverage that your chance even to survive in forex trading are slim to none.
One of the basic terms of forex trading is PIP. You will see that XYZ Broker fees PIP 3 per deal, or XY currency pairs have an average daily range of 100 PIP. We all know that the value of a PIP is a variable that differs with each currency pair, but did you know that the value of a PIP also varies with the current price of the base currency, and with leverage on your account?
For example, with EUR / USD at 1.2723 and leverage of 100:1 the size of a PIP is $ 7.86. At 200:1 leverage PIP value doubled to $ 15.72. For forex traders with different gearing a 100 PIP move means entirely different things to their account equity.
Here is a new way to look at gearing with "K Factor". The three most common gearing ratio available from online forex brokers are 50:1, 100:1 and 200:1. K factor for the 100:1 leverage ratio is 1 K-factor for the leverage ratio of 50:1 is 50, and K Factor of leverage ratio of 200:1 is 2
How can you use the K Factor?
There is three ways of using the K Factor. The first is to use the K factor to calculate the value of a PIP for the currency pairs you trade.
Since 100,000 individual units of currency (usually dollars or euros) is the normal size of a single batch, you can calculate the value of a PIP with this formula:
(100,000 / current price without decimal) * K Factor = PIP
Here's an example: EUR / USD current price is 1.2723, and your leverage is 100:1. With these facts the formula:
(100000/12723) * 1 = 7.86.
The value of a PIP is $ 7.86. If your forex broker carries out your trade at a spread of 4 PIPs you pay $ 31.44 to implement the trade regardless euphemism broker happens to be with the "commission". If your gearing or leverage is 200:1, that implementation will cost you $ 62.88.
The second way you can use PIP and K Factor is to quickly determine the potential profit in a trade, or to know that a certainty the actual U.S. dollar exposure in a stop-loss option.
For example, if you go long EUR / USD at 1.2723, and anticipate a transition to 1.2850 what profit can you predict at 100:1 leverage?
12,850 to 12723 = 127 PIP * 7.86 = $ 998.22 – execution costs.
If you objectively set your stop loss at 1.2715, the amount you are risking in this trade?
12.723 to 12.715 = 8 PIP * 7.86 = $ 62.88 + execution costs.
The third way to use the K-factor is to avoid what forex brokers call it "safety" and what I call "kill, but not dismember."
Margin is not a payment. It is cash-on-hand, your cash, the broker uses to protect its own capital account from your mistakes. It is all very well, because the global forex market will continue to work if all participating brokers have adequate capital to meet their customers' settlement obligations.
If losses from current open positions cause equity in your account to fall below that required to maintain the total number of open positions, the broker's trading platform immediately close all your open positions, even when unrealized losses on an individual's position is quite small. Your loss total PIP per position * K Factor + transaction costs. In almost all cases it is just about everything in your account. This shop opposite, safety net because you will not lose more money than you had in your account (which can and happening with commodities futures accounts.)
The formula is:
(Starting Balance – Open Position Losses) / (($ 1,000 / K Factor) * No Vacancies) -1 <10% = Kill But not dismember.
Most if not all broker platforms keep a running balance of your available margin to help you avoid this fatal situation. If you want to trade more positions and drums of suspected price turning points you should consider creating this formula in a spreadsheet, so you get an early warning long before the situation goes critical.
Mini accounts are based on 10,000 individual currency units with different margin requirements as to make the necessary adjustments in the above formulas before you do the calculations
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