How to Calculate the Risk Exposure of an Expert Advisor

9Expos5211013Why is this task so important when you are Forex trading using an Expert Advisor? This is because Forex trading is an activity that harbors significant levels of risk. Consequently, you can incur serious financial losses if you do not adopt a professional trading attitude from the very startup. In particular, you cannot just purchase an automatic software product, such as a Forex robot; install it and then expect everything to work exceptionally well without exerting any effort on your behalf.

Such a course of action would be very dangerous as you would be risking your entire account balance on the performance of a tool that you have made no attempts to verify. Specifically, you need to know, as a minimum, how your new device handles risk exposure. For instance, you need to gain a solid understanding about how well your robot will handle leverage and margin otherwise you will run the risk of sustaining serious monetary drawdowns when it starts trading Forex on your behalf.

 

What are Leverage and Margin?

Here are two common definitions.

Leverage involves the use of borrowed money to enhance the potential return of an investment.

Margin is the funds that you must deposit as collateral in order to cover any potential losses from adverse price movements.

Basically, they are both describing the same feature of Forex trading but from a different perspective. Leverage allows you to open a Forex position of considerable worth by using just a small deposit. For instance, if you can attain a leverage facility from a Forex broker of 100:1; then you would be able to activate trades worth $100,000 with equity of just $1,000. Leverage is required in Forex trading in order for you to open trades that can provide you with worthwhile profits.

In the above examples, if the equity that you needed to support your leveraged positions was $1,000, then this would be your margin. In addition, you must understand that as your margin deposits are a requirement for supporting your leverage facility, they do not represent direct costs.

 

How to use Leverage and Margin

You can obtain an understanding about how to achieve these objectives by considering an example. Imagine that you have opened a EUR/USD trade with a position size of $200,000. If you utilized a leverage facility of 100:1, then you will only require a margin of $2,000 to support this trade. The following table displays the different requirements of various position sizes, leverage and margins.

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This table should help you appreciate the combinations of leverage and margins that you will need to use in order to support various position sizes. However, you must understand that your margins are the equity that is needed to back your leveraged positions. As such, they do not represent the total amount that you could lose should price advance against your trades. In fact, you could lose substantially more if you did not utilize sufficient protection for your account balance.

 

Understanding the Risks involved

You must always keep in mind that using a margin account with a leverage facility can dramatically increase the size of your losses. For instance, if you had a total an account balance of $2,000 and your expert advisor opens a leveraged position worth $100,000, then each pip would be worth $10. Consequently, if price advanced against your position by 200 pips, then you would lose your entire equity.

As such, you must always ensure that your Forex robot does not utilize leverage recklessly by opening positions that can expose your equity to unsubstantiated levels of risk. You must verify that your product makes the protection of your account balance its number one priority. However, a large number of Forex expert advisors completely fail to control the dangers of using a margin account with leverage which is one of the prime reasons why 95% of them fail.

You will find that many Forex brokers display the minimum margin requirement (MMR) for each currency pair depending on the leverage facility of the account. The following table illustrates the MMR values for a number of currency pairs by indicating the margin required, in dollars, to open just one lot of each pair. For example, you will require $50 to activate a 1 standard lot EUR/USD position.

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Used and Usable Margins

 

After you have purchased a Forex expert advisor and started trading it, you must verify that it utilizes used and usable margins to help control leverage.

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For instance, you will normally find that these two parameters are displayed as shown in the above diagram. Usd Mr is the abbreviation for Used Margin and is the value of your account balance that is required to support your opened leveraged positions. Usbl Mr represents Useable Margin and is the amount of your equity that is available to support your presently opened positions and any new ones you plan to activate.

If Usbl Mr should ever drop to $0, then your broker will issue you with a Margin Call. This is a very undesirable event as it implies that your account balance can no longer support all your active Forex positions. When a margin call is issued, all your open trades will be instantly closed and you could incur substantial losses.

Margin calls are usually generated by the misuse of leverage. They cannot only produce serious losses but can also create a significant drop in your trading morale. You must therefore always make sure that your expert advisor watches the useable and used margin figures of your account very carefully in order to prevent such situations arising.

This is why your Forex robot must use leverage with caution because it is a double-edged sword that offers the chances of increased profits but only with the prospects of magnified risks. The next section will demonstrate how you can determine the risk exposure of an expert advisor.

 

Calculating the Risk Exposure of a Forex Robot

Envisage that your new Forex Expert Advisor utilizes a money management strategy that allowing it to risk between 2% (default) and 10% of your total available equity per trade. The EA calculates the Position-size (PSP) and Stop-loss (SL) of each of your trades in order to satisfy this important specification.

The following process shows you how it does this. PIP stands for Percentage In Point and is the minimum price change that can occur in Forex trading. As you can only have one trade active at any one time, then your free margin will equal your total equity. Imagine that your total equity is $10,000 and your stop-loss is 20 pips. Also, assume each pip value (PV) equals $10 (Standard Account) for each one standard lot traded. The risk exposure is then calculated as follows:

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Automated Investing

EAs automate short term trading. For longer-term, automated investing you should familiarise yourself with robo advisors. Algorithms allocate funds according to preset criteria, inline with your investing goals. Visit www.roboadvisors.com to find out more.

 

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