OVERLEVERAGING — THE RISKS OF FOREX LEVERAGE

We have already discussed what leverage is, and what it offers to the trader. Let us here take a look at the impact overleveraging can have on trader psychology.

As we mentioned above, the best trader is he who can detach himself from his emotions during his trading activity: one can have as much excitement and joy as he desires while enjoying the fruits of his achievements, but during trading itself, the heart should beat softly, and the brain should be in charge. Needless to say, a high-risk, all-or-nothing environment where any slight mistake can wipe out the trader's capital is not the environment that is conducive to creating such a mentality. Mistakes will inevitably happen during trading; neither man nor machine is capable of predicting every movement of the market precisely. To ensure that the mistakes that occur do not eliminate your capital, your self-esteem, and your chance of learning from your errors, do not over leverage.

High leverage works against the speculator by increasing the stakes and making the heart beat faster. No one jumps in his seat over the loss of a couple of dollars through which lessons are learned and mistakes recognized. But as potential losses increase, the beginner will have no time to focus on the lessons from his deficiencies, but instead will agonize over his stupidity at having risked so much money in a bet that didn't possess much chance of success anyway. And there begins the vicious spiral of fear, and losses which can eventually ruin a good man's livelihood.

But if the reader is afraid of the large holes that leverage can open in his pockets, he should also keep in mind that there's nothing related to the forex market per se that is dangerous and harmful. Forex is perhaps the safest of all market, since in general the prices move very slowly, and unlike in the stock market, the wipe-out of an unleveraged account is almost impossible: let us remember that nations do not go bankrupt, and currencies don't go to zero in general. But because many people see forex as a get-rich-quick scheme, and expect nonsensical levels of leverage to work for them, more people fail in this market than those who succeed.

To hopefully clarify this matter even further, and to let the incredulous reader reconsider his opinion, I'd like to remind him that the bankrupt Wall Street firms of 2008, like Bear Sterns, Lehman Brothers, Merril Lynch, had leverage ratios of at most 35 to 1, even in the worst cases. And there doesn't exist a person in the world today who doesn't, in hindsight, recognize how foolish and irresponsible it was to take that much risk. But if leverage in the thirties was bad enough for the giant Wall Street firms, with US government and international backing behind them to recapitalize them repeatedly before they went bankrupt, or were forced into gunshot marriages, how wise can it be for the "average Joe" to leverage his account in the fifty or even a hundred to 1? Given that the forex market is erratic, and unpredictable in the short run, how much wisdom can there be in overleveraging?

Remember, if you can't create great returns at low leverage, there's absolutely no reason to expect to do so on high leverage, and every reason to expect massive losses instead.

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Fed Members Continued To See Tapering This Year, Despite The September Disappointment

Although the Fed failed to announce tapering in September, the FOMC minutes unveiled that most policymakers expect it to begin this year. The minutes showed that the Fed decision to not taper last month was driven by the tightening in financial conditions, uncertainty over the fiscal outlook and the ambiguous economic data released since the June meeting. Meanwhile, policymakers were divided into 2 camps when considering whether to taper with the first camp mainly concerning about whether economic conditions warranted tapering while the second focused on how the tapering decision would affect the credibility of the Fed monetary stance.

The minutes indicated that some members saw financial conditions as tighter and a risk from "sizable increases in interest rates' although the intermeeting data suggested that the economy was 'expanding at a moderate pace'. Meanwhile, 'household spending and business fixed investment advanced, and the housing sector was strengthening, but mortgage rates had risen further and fiscal policy was restraining growth'. Yet, others viewed that 'cumulative progress' in labor markets since the beginning of the QE warranted reduction of stimulus. They believed that monetary policy credibility would be 'best served by announcing a downward adjustment in asset purchases' at the meeting while any postponement 'of such an announcement to later in the year or beyond could have significant implications for the effectiveness of Committee communications'.

Concerning the forward guidance, some members expressed the concerned that a 'delay could potentially undermine the credibility or predictability of monetary policy by, for example, increasing uncertainty about the Committee's reaction function and about its commitment to the forward guidance for the federal funds rate, with the result of an increase in volatility in financial markets'. The Fed members also 'discussed the potential for clarifying or strengthening the Committee's forward guidance' and the steps suggested include 'stating that the Committee would not raise its target for the federal funds rate if inflation was expected to run below a given level or providing additional information on the Committee's intentions regarding the federal funds rate after the 6.5% unemployment threshold was reached'.

Policymakers had a vigorous debate about whether to taper in September and how the process should work. It's stated in the minutes that 'a few participants expressed a preference for not cutting MBS purchases but reducing purchases only of Treasury securities initially, with the intent of continuing to support the recovery in the housing sector'. With respect to the economic projections, the minutes indicated that 'most participants viewed their economic projections as broadly consistent with a slowing in the pace of the Committee's purchases of longer term securities this year and the completion of the program in mid-2014'.

In short, the minutes were a dovish one. Yet, most member continued to expect tapering to begin later this year but economic data, especially those reflecting the labor market situation, are the deciding factors.

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TRADING PSYCHOLOGY

Human beings are emotional creatures. We love, we hate, we adore, worship and despise, we can be enthusiastic, and we can be cautious. The canvass of our lives is colored by the palette of emotions, and indeed it's impossible to define a human being without depicting his emotional reactions to life's various occasions.

To the better or worse however, the canvass of profit is colorless. Neither the blush of euphoria, nor the blues of depression have any bearing on the landscape of forex. The successful trader should attempt to banish the shades of pride from his heart when he succeeds, because the market is fickle, and quick to punish those who foolishly feel that they have "cracked the code of forex". But neither should the trader have any feelings of shame or sadness about his failures: failures pave the path of experience leading to success, and as long as he recognizes that he's not ready to embark on big risks, he can survive any calamity that the forex market throws on him by simply risking little, and employing low leverage.

And yet an enormous number of speculators have been unable to act by these simple principles. Desperation and excitement, greed and fear delude many people even after experimentation and study, and success in trading can elude even a genius like Sir Isaac Newton, if he's unwilling to fight his emotions, be deaf to the crowd, and follow the dictates of logic.

So we expect the trader to reason rather than feel, and to calculate rather than dream. We want to take emotions out of the deal, and we don't just want to remove those such as fear, apprehension, worry, anxiety from our trading experience, but also excitement, courage, euphoria, and the other so-called positive emotions, in order that we don't overestimate our skills and power and take more risk than we should take. How do we achieve that?

The only way of achieving this aim, and successfully managing our psychological responses during trading is understanding what we do, and doing what we understand.

Once the trader is aware that his success is not a gift from angels, and his failure is not bad luck, or karma, but the logical consequence of wrong choices and indiscipline, there will be little cause for any emotional ruin, or gratification. Success in the market should be as simple as a good meal enjoyed after hard work. And failure should be as harmless as the bite of a mosquito, because risking more in a highly leveraged trade will never grant anyone success: it is always possible to begin with small sums, gain confidence while scaling-in, and even those small sums will translate to great profits in time. And if they do not, what would make us think that adding to the account or changing leverage will change our fortunes?

And I'd like to repeat here once more in response to the many online get-rich-quick schemes that proliferate: success in the forex market, and in fact in all financial markets, is not dependent on knowledge of some secret formula, or some magic indicator, or a prodigious intellect: all that is needed is discipline and study. To study the causes of economical events, and understanding them, thereafter devising, or adopting a clear and uncomplicated technical method, and adhering to that with principle and discipline is all that is necessary for success. But it must be remembered that nothing more and nothing less will do either. And the trader should get rid of all dreams of overnight riches without labor: who knows, maybe overnight riches will be possible for some individuals, but even then not without hard work and reflection.

Let us examine two major problems that cause traders to lose their wits, and turn the forex market into some kind of Russian roulette where it is impossible to maintain calm during trade decisions: the problem of undercapitalization and overleveraging.

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Italy's Political Turmoil On Bonds And Cost Of ECB Funding

Political uncertainty in Italy again raised market concerns. Volatility is expected at least in the near-term as Prime Minister Letta might need to find sufficient support to remain in the government. An early election of the government cannot be ruled out although the likelihood is not high. Bond investors are mostly concerned about the impact on credit ratings of Italy's sovereign bonds. With all of S&P, Moody's and Fitch putting Italy in negative outlook and ratings marginally investible, a downgrade would cause huge liquidation. Meanwhile, the potential haircut for the Italian government bonds by the ECB worsens the situation.

Silvio Berlusconi asked 5 ministers of its centre-right PDL party to resign last Friday, triggered by the government's failure to agree on budget measures needing to keep the general government budget deficit below 3% of GDP this year. The decision was described by Prime Minister Letta as “mad and irresponsible” as Berlusconi “solely finalized to cover his personal travails”. Note that Berlusconi lost a final appeal in a tax fraud case and is expected to begin a one-year prison sentence, most likely in house arrest, in mid-October. While Letta has not yet accepted the resignation, he has announced that he would ask for a vote of confidence in parliament in the next few days, possibly on Wednesday.

A number of possibilities can be expected in the consequence. With the mixed opinion about Berlusconi's call for resignation within the PDL, it might be likely that Letta would find sufficient support to retain a majority in parliament by gaining support from several PDL dissidents. If there lacks support of the parliament new government has to be formed or an early election would be carried out.

No matter which scenario materializes, market volatility is expected, at least in the near-term. Concerning the credit ratings, S&P, Moody's and Fitch assigned Italy with BBB (negative outlook) on July 9, 2013, Baa2 (negative outlook) on July 12, 2012 and BBB+ (negative outlook) on March 8, 2013 respectively. All of them stated at that time that political uncertainty was a key factor triggering the downgrade as it would affect implementation of structural reform. However, we expect the agencies would take a wait-and-see mode this time before making any adjustment. Any downgrade would strip Italy's bond off the investment grade, causing a number of funds to liquidate.

Canadian rating agency, DBRS, placed Italy at A-, with negative outlook on March 6, 2013. A downgrade would raise the cost of the Italian banks' funding at the ECB operations. In July, the ECB raised haircuts for Eurozone sovereign debt (Category I) by 0.5% to 2.5% for BBB+ to BBB- rated countries, while reducing haircuts on paper rated AAA to A- by 0.5%-1%, depending on the maturity of the bonds. Helped by the ECB's “first-best” rule, haircuts on Italian bonds are still low with DBRS' A- rating. A downgrade would put Italy's collateral into a lower category, hence raising the cost of borrowing.

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The Fed Wins a Pyrrhic Victory

So the Fed didn't taper, risk assets are rallying (although they are pulling back today in a post Bernanke hangover), and bond yields are falling. Perhaps the most important yield to fall is the 30-year mortgage rate, which fell back to its lowest level for a month after the Fed announcement. One of the reasons the Fed decided to stay its hand was because the prospect of tapering had caused the housing market recovery, which started in 2011, to stall. The housing market is huge in the US, not only does it create a large amount of employment and growth, i.e., retail sales are mostly made up of what people buy for themselves or to put in their homes, but it is also a key ingredient in consumer and investor confidence. If your house price is rising then you feel rich.

It's all about housing

So, a threat to this important sector of the economy could not be tolerated by the Fed. As you can see, the 30-year mortgage yield is still a full 100 basis points above where it was back in May, before Bernanke had riled the market with his taper talk to Congress. Thus, the Fed could take its time with tapering for as long as it takes the housing market to get back into recovery mode.

The Fed's pyrrhic victory

Essentially, the Fed didn't end up having to do anything yet it got the desired effects - back in May, by touting tapering, it helped life interest rates, thus averting bubble territory, now by refraining from tapering yields have backed away from recent highs. But Bernanke is no market Svengali, his move last night is still costing the Fed $85bn a month in asset purchases, the Fed's balance sheet is still enormous, at more than $3.6 trillion. QE-3 can't go on forever and tapering will happen, but right now the Fed is taking its time over ripping off the plaster. When will it have consequences? It depends when the size of the Fed's balance sheet become a problem. Will it be accused of monetizing the US's enormous debt when it hits $5 trillion, $10 trillion? Who knows, but the Fed is playing a dangerous game and will have to rip the plaster off the wound at some point and it won't be pretty.

The Fed does the ECB a favour

In contrast, Mario Draghi has managed to talk the Eurozone sovereign crisis down without spending a penny - the ECB's balance sheet has been shrinking rapidly since the start of this year and is 20% smaller than it was in January. In fact the Fed did the ECB a favour - the rise in Treasury yields since May had weighed on global G10 yields, pushing up borrowing costs for Spain, Portugal etc. These countries already have precarious finances, so rising borrowing costs were starting to cause some concern. Now that tapering has been put firmly to bed, yields in Europe's periphery have fallen.

Post FOMC ECB cheer could be short-lived

The biggest problem for Draghi could be a rising EUR. EURUSD jumped to its highest level since February post the FOMC meeting. Back in early Feb when EURUSD jumped above 1.3600 the ECB managed to talk it down by some 800 pips in 6 weeks. However, in the coming days, a win for Merkel, and for the FDP party, which would avoid a grand coalition with the Social Democrats, may drive a relief rally in EURUSD on Monday. However, if we make fresh 12 month highs in the coming days in EURUSD this increases the risks of intervention from the ECB at its October meeting.

The effects of the Fed bottling it on tapering last night could be felt for some time.

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