How Leverage Affects The Individual Trader

Teresa, November 29, 2007 @ 5:08PM ET | Link | RSS | Read via Email | Start a Discussion  

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.

Before The Trade: Working the Numbers

Before trading, the trader needs to work the numbers to ensure that the leverage being contemplated is reasonable. Here is a typical conversation I have with traders that write in.

Trader:
I have been trying for hours to come up with something profitable for GBP/JPY. I cannot seem to set up anything that works for me in forex.

Teresa:
If you don’t mind me asking, could you tell me how much leverage you are using with forex? 1 dollar of your own money to control ___ forex?

Trader:
1:100

Teresa:
It may be quite challenging to find a trading method or system that can handle 1:100, since the account can never be down more than 1% without bankruptcy. The 1% also has to be divided into smaller chunks, say, 10, to accommodate a potential string of losses, meaning that each trade can never be down more than 1/10 of 1 percent. That is an awfully small stop.

Trader:
What can you suggest on a 1:10?

Teresa:
To be honest, I have never traded at 1:10, so I don’t have an instant reply. But one suggestion is that whatever method or system you use has to work with the amount of leverage.

So for example, at 1:9, $100 your own money and $900 on margin for a total of $1000, the most the account can be down is $100 before the equity is gone. And since you have to provide some room to accommodate a potential string of losses (we’ll use 10), then no individual loss can ever be larger than $10, including commission. So $10/$1000 = 1/10 of 1 percent is the tightness of your stop. This is really tight.

Let’s work the numbers. Say you’re trading a stock currently at $100. At this level of leverage, it means that your stop loss can only be 10 CENTS. Since stops must be placed according to range and volatility, you then have to find a time frame small enough where a 10 cent stop can account for range and volatility. And that might be a one-minute chart where there is poor liquidity and price action. Commissions will also add up on small time frames since there will be many more trades.

There are a lot of moving parts here, and you have to work all the elements back and forth until you come to something. From my experience, this generally means going to larger time frames and lowering leverage.

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