Are you Paying the Piper for Pips?

Joshua Martinez |

In trading the Forex market, you can’t escape the numbers. Equity management, account size, lot size, pip potential; no matter how hard you try, there’s a mathematical price to be paid before entering a trade. While the numbers I’ve named may come as no surprise, what about this one -- what about the premium you pay for market volume?

In the wrangling returns game within the market, it’s hard not to think about the price being paid for winning a particular trade in the case that the trade is lost, but what about the premium that it takes to even throw your hat into the ring? When you’re looking to drastically increase your returns and play money manager rather than hobby trader, the premium paid to place a particular trade matters.

This is what I mean: Take the USDMXN versus a more common pair, say the USDJPY. In the USDJPY pair and many other major currency pairs, a regular mini lot position could cost $200 on average to get into a trade where you’re expecting to earn one dollar per pip won. This is important when you consider account leverage and proper risk management, so we typically would calculate this out before entering a position. Then there is the goal -- what do we expect to win. Say your goal is to capture 3000 pips, at this point it comes down to predicted volume. In this pair in particular, the charts show an average of 50 pips of movement per day. With the USDJPY, we’re looking at spreads of about 3-5 pips. Even if the market moves in a completely straight line rather than the natural wave-like movements we’ve come to expect, it would take 60 days for the position to fulfill and that $200 initial investment would close out with a $3,000 profit.

Now, take the exotic USDMXN. This pair has been known to move the same 3000 pips of movement within just 10 days; that’s only a sixth of the time that it would take to capture the same amount of pips and make the same amount of return as on the USDJPY. USDMXN averages about 15-pip spreads between the hours of 2:00 a.m and 4:00 p.m. All other times, you can see hundreds of pips in a spread on this pair. But of course there’s a catch. For this pair, it could cost you roughly $6,500 to trade the same regular mini lot size, hence, you’re essentially paying a premium for volume and for the luxury of spending less time waiting on that trade to fulfill the 3,000 pips.

So then, we as traders are faced with a bit of a dilemma. You can either trade for a quicker reward or you can trade for a longer stretch to get the same reward. The choice is really yours, but when faced with this dilemma, I want to share with you what I consider the most.

Everything, and in my opinion I mean everything, comes down to strategic trading not for money, but for safe account growth. What defines my decision in circumstances like these is my equity management and my personal risk tolerance.

I personally learned to trade from Jared Martinez, my father. He always taught me that you should never risk more than five percent of your total trading account per trade. While I’ve tested my luck at risking more at one point or another, I found that this is truly a trader’s golden rule. With this said, I would need to ensure that my total trading account be around $10,000 to keep my risk to reward ratio in check. If I were to only risk one percent of my account, I could do a 1:2 risk to reward ratio, meaning I’d only have 100 pips at risk per mini lot traded. Now, this is where things get a bit personal. For some traders, even that risk is too much to stomach. When you look at the equation in this manner, you might say that the USDMXN premium for volume simply isn’t for you as a trader. While that’s fine, the important part is being able to identify what you as a trader are comfortable with and what that means for your currency pair choice.

In the risk tolerance arena, I have my own approach. My approach says that if I’m going to trade a certain lot size, I ask myself, “can I afford to lose 10 trades in a row and still place the 11th trade at the same lot size?” If I can afford it without feeling that the drawdown on my account would hurt me too much, then I can tolerate that risk. On the other hand, sometimes I say, “you know, I would have to change my lot size,” chances are that I’m probably over-leveraging my account and I’ve entered into gambling with my emotions and my money and that’s not the way I choose to trade.

When you’re thinking about entering a trade, you have to consider the numbers and when you look at the numbers, it’s wise to consider the premium that you’re paying for any given currency pair. While volume is great, you have to consider the cost to enter the trade (the premium) and the amount of leverage that premium costs on your account. Both trades could get you the returns you want, but the overall effect that trade could have on your account in the worst case scenario does indeed matter. From my experience, in the “paying the piper for pips” game, your risk tolerance and equity management should always be in line so that if the piper comes to collect, you’re not left counting a debt.

By Joshua Martinez, Market Traders Institute, Inc.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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