Press Digest for Friday

How Leverage Affects The Individual Trader

29-gears.jpgThe past few years has seen its share of high-profile blowups in the hedge fund industry. Traders find it incredible that professional traders — hedge fund stars with all the resources at their fingertips — could be “this stupid”. I can think of two reasons why this happened, and stupidity is not one of them.

First, potential investors do not want to invest in a hedge fund that promises 10% per year. They want their risk capital to return a lot more, forcing hedge funds to squeeze blood from a stone with exotic strategies. Or else they cannot get money from the client.

Second, since there is only so much return that can be had from any strategy, the only way to increase returns is to use more leverage. And of course, that cuts both ways. When it’s up, it’s up a lot. And when it is down, it is over and out.

Leverage and The Individual Trader

New traders are typically undercapitalized, and tend to gravitate to highly leveraged markets such as forex and futures. This always results in wild swings in the account equity.

Because individual traders rarely contemplate the implications of leverage, huge fluctuations in account equity are easily interpreted as bad trading or “lack of discipline”. The blame is inevitably placed on an inadequate trading system or deficient technique, yet few realize that there is a structural reason behind the problem: excessive leverage.

Leverage warps the perception of risk. The reflex is to tighten stops based on how much the trader can lose instead of using stops based on range and volatility. This generally results in trades being prematurely stopped out, and when that happens, the trader usually moves to ever-smaller time frames. At this point, commission and slippage eat up much of the potential profits. The trader has to sprint just to stay in the same place. It becomes a vicious cycle.
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