A recent study conducted by researchers at FXCM, a leading forex and spread betting company, shows that forex traders with smaller account sizes are less profitable than traders with larger funds in their accounts.

Researchers at FXCM investigated thousands of forex accounts held at the company and identified a pattern: smaller accounts lead to less profitability. According to the report the reason lies in the level of leverage used. When account funds are lower, traders tend to leverage their accounts too much while traders with larger accounts are more averse to leverage and trade with more parsimony.

The following table and chart show the percentage of profitable trades and leverage per account funds.

Traders with less than $1,000 in their accounts engage in much more leverage than traders from other groups. On average, these traders leverage their account 26 times. As a result only 20% of them run a profitable balance from forex trading. As account funds grow, traders become more averse to risk, reducing their leverage. A direct effect is an increase in profitability.

FXCM researchers explain that new traders are inexperienced in the forex market and tend to open accounts with fewer funds than experienced traders. The smaller the account size the less risk averse a trader is. In order to make decent gains, a trader needs to engage in high levels of leverage, risking too much. The trader is not much concerned with losing it all and will make risky trades. To change his attitude towards risk, the trader needs to guess market direction too many times in a row given his limited account size. That is an unlikely scenario, and the trader end losing all his funds.

The research made at FXCM for forex accounts applies to spread betting in general. In prior articles we have been advising traders to avoid risking more than 2-3% of account funds in a single trade and to avoid levels of leverage that are higher than 3-5 times the account size. When leverage is higher than that, it is very unlikely a trader can survive any drawdown. Inexperienced traders don’t think about the possibility of losing several trades in a row but that is a probability that must be accounted for. Just think on the roulette game as an example. The probability of a number being red or black is roughly 50%. Nevertheless it often occurs that the number comes 5,6, or even more times of the same colour in a row.

In order to check the leverage for your account you can use the following formulas:

Leverage = Notional Value of Trades / Account Size

Notional Value of Trades = Sum for all positions[ (Market Price X Stake) / Unit Bet]

Let’s suppose your account is currently valued at £5,000 and that you hold the following positions:

-       FTSE 100 quoted at 5,430 with a £4 stake

-       DAX 30 quoted at 5,700 with a £4 stake

-       EUR/USD quoted at 1.3025 with a £4 stake

First of all, let’s compute the notional value of your positions:

-       FTSE: 5,430 X £4 X 1 = £21,720

-       DAX: 5,700 X £4 X 1 =£22,800

-       EUR/USD: 1.3025 X £4 / 0.0001 = £52,100

Now, it is easy to sum it all and get the total notional value, which is currently £96,620. Using the second formula above, we get a leverage value of 19.32. That is probably too much and you should reduce it to avoid being caught off guard. To avoid losing too much you would need to set too tight stops that will put you out in a very short time. If you instead set a wider limit then you can end losing too much on these trades. Let’s say you set a stop 1% below the current price. Stops for FTSE, DAX, and EUR/USD are then held at 5,375.7 – 5,643 – 1.2895, respectively. If these trades are closed at the stop level, you can lose up to £965.2, almost 20% of your account funds. One way or another, the probability of ending with no funds in your account is high.

Given FXCM research and what was said, you should either increase your account size to help reduce leverage, or directly reduce your exposition while keeping funds. You should set a reasonable leverage level, and then adjust positions to fit that level.

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