I Frequent several forex trading message boards and often see questions like the following from individuals who are just getting into Forex:

My broker only allows me to trade with leverage as low as 10:1.  I don't want to risk that much - can I somehow set it to 1:1?

This type of question reveals a misunderstanding of leverage that many new traders have.  Leverage does not equate to risk.  It simply dictates the largest size of a position or positions a trader can take.

I came across a clear and simple explanation about the difference between these two concepts tonight in an article entitled What leverage is really all about, written by John Forman at The Essentials of Trading.  Since I couldn't improve on the author's explanation if I tried, I've copied an excerpt below (emphasis mine):

Allowable leverage tells you one thing - how big you can trade, either in terms of position size or number of positions. That’s it. No more. No less.

Risk comes down to one thing, and one thing only - the size of your position. The larger the position, the greater the risk. It’s that simple, really. High degrees of available leverage certainly allow for larger positions, but they do no require them.

The thing that I think causes the most confusion is thinking in terms of margin and not account size. If you trade at 100:1 leverage you would have to put up 1% margin. That means a 1% move in the market against you would wipe out your margin deposit. If you were trading on 50:1 leverage the same 1% move against your trade would only take out half your margin. That seems like less risk.

Here’s why it isn’t.

Assume a $10,000 account and a $100,000 trade size. For a 100:1 leverage account the margin requirement would be $1000, while at 50:1 it would be $2000. If the market moves against the position by 1%, that would mean a $1000 loss to the account, or a 10% decline in account value. It doesn’t matter whethere the trade was done in a 100:1 or 50:1 leverage account. A 1% move on a $100,000 position will always represent a 10% change in account value for a $10,000 account.

The only time differences in leverage mean differences in risk is when you are talking about different position sizes, basically meaning using all available funds for margin. The 100:1 leverage $10,000 account could trake $1 million, while the 50:1 could only go as high as $500,000. Clearly, when the accounts are maxed out like that a 1% move in position value is different. The 100:1 account would be wiped out, while the 50:1 account would only lose have its value.

So, assuming a constant position size, a trader does not necessarily risk more by using higher leverage.  Higher leverage just means that the trader can take a larger position or more positions if he/she so chooses.  Hopefully this will help clear up this mystery for some.

Stops are an important weapon in most traders' arsenals, and a good exit strategy will keep a trader from losing too much on a trade or giving too much back after a trade moves in to profit.

Though I agree that every trader should have an exit strategy prior to entering a trade, I've often struggled with determining which of the myriad of strategies is the best approach.  Which strategy will maximize my profits and minimize my losses, while at the same time not stop me out before my trade really takes off?

Here's what I've come up with over the years...

Initial Stop

Part of planning my trade before I ever place the order is determining where my initial stop will be placed.  In fact, the distance between my entry and my stop determines how large my order will be, so I don't know how many units I can buy or sell until I know where my stop will be.  I like to place my initial stop just below the recent swing low when I'm going long or just above the recent swing high when going short.  There are two reasons for this:

1. I place my trades in the direction of the prevailing trend when the market is making higher highs and higher lows or lower lows and lower highs.  If price takes out a prior swing high/low, I will no longer have a reason for being in the trade.
2. Placing my initial stopped based on a prior swing high/low takes volatility of the instrument I'm trading into account.  If I were to use a fixed pip amount for my initial stop, on the other hand, it may be too close or too far for the current market conditions.  A 100 pip stop, for example, which might have been suitable for the EUR/USD a year ago, is too close for times of increased volatility like we've seen this past month.

Breakeven Stop

As soon as my trade moves in to profit by a reasonable amount, I like to move my initial stop to breakeven.  This allows me to, as the old adage goes, "Never let my winners turn into losers."  By moving my stop to breakeven, my trade essentially becomes risk-free and I can let it run for as long it wants to move in the right direction.

Trailing Stop

If I haven't been stopped out yet and my trade continues to move in my direction, I'll start to periodically move my stop to lock in profits.  I've never been fond of using profit targets to exit my trades - I know some traders use them with great success, but they don't fit my personality - so I like to use trailing stops as my profit-taking exit strategy and let the market take me out when it's ready to turn.  I haven't, however, completely settled on the type of trailing stop I prefer, so usually I'll open a position and exit half of it based on the first of the following two methods, and exit the other half based on the second:

1. Trailing Stop Based on Price Action -When the instrument I'm trading makes a minor pullback (that doesn't stop me out) and then resumes its trend, I adjust my stop to just below/above the recent pullback.  I like to keep my trailing stop below/above the most recent pullback for the same reasons that I place my initial stop just below/above the recent swing.  If the market turns against me and takes out my stop, my reason for being in the trade is no longer there, I take my profits and move on to looking for the next setup.  This method works great in a market that is consistently making higher highs and higher lows (or LHs and LLs) in an orderly fashion.
2. Fixed Amount Trailing Stop - When the instrument I'm trading makes a new high (or low), I adjust my new stop to be the distance of my initial stop below (or above) the new high (or low).  This type of trailing stop generally locks in pips faster, but has a higher risk of stopping me out early before the trend has reversed, leaving pips on the table.  On the other hand, if the trend is not strong or nearing its end, this strategy can make some pips where the former trailing stop strategy might not.

I think both of these trailing stop methods are sound strategies, and time will tell which one is better or if they are better used in conjunction, as is currently my practice (using the first method for half of my position, and the second method for the other half).  I work full-time on weekdays, and the platform that I use does not offer trailing stops, so I adjust my stops manually a couple of times during the day (usually once in the morning, once around lunch-time, and once in the evening).

I've been reading a lot recently about the importance of setting goals for one's trading.  For so long, my only objective has been as nebulous as simply making money or becoming consistently profitable.  However, setting realistic goals that can be measured can play an important role in a trader's performance.  They offer a real objective and a means by which one can measure his/her progress.  So, starting this month, my monthly goal will be an increase of at least 2.5% of my account.  Some months I may fail to meet my goal, and some months I may surpass it, but every month I will shoot for at least 2.5%.  I figure that 2.5% is an attainable goal, since I risk roughly 2% per trade.  If I can get a couple of good trades per month while cutting my losers quickly, I should be able to meet my goal.  When I can consistently make 2.5% per month, I'll reevaluate my monthly goal and consider increasing it.

I’ve traded both equities and futures in the past. I eventually ventured into Forex and I’ve found that it is the market that best suits my personality and my trading style. So here are some of the reasons why I trade the Forex market versus other markets. Have any to add? Feel free to post a comment!

• Low minimum capital requirement: I trade with a small account (especially since I’m still working towards becoming consistent), and Forex allows me to trade an appropriate size relative to my account and trading style without risking too much. The broker that I’m with, Oanda, lets me trade any size that I want. All of my trades at this stage are in the hundreds of units, for the most part, which means I’m risking around $20 per trade.

• Low transaction costs: In the futures and equities markets, you are charged a commission, plus a spread, plus other fees in some cases whenever you place a trade. In Forex, you are only charged the spread, which for most major pairs is a couple of pips. Since I trade small size, the amount that I end up paying my broker per trade is pennies, compared to a few bucks per roundtrip on a futures trade or a buck or more on a stock trade.

• Trends well: I’ve read that the Forex market trends better than any other market. People attribute this to its macro-economic nature, or its liquidity, etc… Regardless of the reason, I have noticed in my time since I began to watch the Forex market that the major pairs trend more often than not, and that the trends tend to be long-lasting trends.

• Well-suited to technical analysis: I’ve also read that Forex is particularly well suited to technical analysis, due to the fact that its trading volume dwarfs all other markets and the markets never close.

• Always moving: The Forex market is open twenty-four hours a day, and when things have died down in the U.S. session, they are just picking up in the Asian session. As the Asian session winds down, the European session gets going. As a result, there’s more opportunity for movement and fewer gaps.

• No restrictions on short selling: Unlike with equities, there are no restrictions on short selling. In fact, whenever you buy one currency, you’re shorting another at the same time. So, while it may be easier to capitalize on uptrends rather than downtrends in the stock market, in Forex it’s just as easy to go long or short.