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Traders - How Leverage Can Blow You Up!

April 09, 2012 | Comments: 0 | Views: 151

I've seen many articles refer to but not define leverage very well, and it is of utmost importance if you are trading the financial markets. Here we go, but first realize that leverage feeds greed, and if not kept properly caged can blow up your trading account very, very quickly.

In simple terms leverage can make your trading account behave much bigger than it actually is, multiplying up gains and losses many times over and exploding returns on the real cash you hold, both positively and negatively. It is created through the use of derivative trading and the concept of margining your trade exposure rather than stumping up real cash for what you have purchased. An easy way to illustrate this concept is on an equity trade, either traded spot (immediate delivery) or in futures form (future delivery), and let's assume we are doing all of this in Apple Inc shares.

Today Apple is trading around $630 a share (I can see a snigger when someone reads this article in 5 years' time!).

On the spot market, 100 Apple shares today would cost you 100 * $630 or $6300, so as a minimum you would need that amount in your brokerage account (assuming your broker is straight up and down). Your exposure on this trade is $1 per point where a point is defined as 1 cent. To test this, if Apple shares move from $630 to $630.01 you profit is 1 cent * 100 shares or $1, simple.

So in summary, at current prices you need $6300 to get $1 a point on Apples Inc shares in the spot market.

Now let's talk about futures and in this particular instance a single stock future on Apple Inc. These are available through the OneChicago Single Stock Future Exchange and are offered by many brokers, usually with a margin requirement of around 20% or in some instances less, but for this example let's assume the requirement is 20%.

With these contracts you define the exposure per point you want and then work backwards. To make the comparison to the spot market I want $1 per point in the futures market. This means I need to trade a notional size of 1 point * $1 * $630 * 100 (points in the $) which happens to equal $6300 but, and this is the crucial difference, the exchange only requires a 20% margin on this transaction or $6300 * 20% which is $1260.

So in the futures market you need $1260 in actual cash to get $1 a point on Apple Inc shares compared to $6300 in actual cash in the spot market - and that is what leverage is (this is 5 times leverage, 6300/1260).

Ok why the danger - greed will cause people to over-leverage.

Let's assume the Apple Inc share price moved from $630 to $620 in the day. On the spot market you have lost $10 * 100 shares or $1000, so you are left with $5300 in your account for a negative return of 15% for the day. A corker and likely to ruin your evening but you are still alive and could wait for the rebound if that was your strategy.

On the futures market you have lost the same $1000 and are now left with $260 in your account for a negative return of 79% on the day. I think that will be the end of you unless you find some more cash!

But, let's say you did have $6300 in cash to play with, a greedy guy could afford $5 a point in the futures market at a 20% margin (1 point * $5 per point * 630 share price * 100 points in the dollar * 20% margin requirement = $6300), yep that's enough cash for $5 a point. But at dinner time you would be eating a loss of $10 * 100 * 5 or $5000 and that would ruin my day.

The answer: by all means trade futures or other forms of leveraged accounts (there are a few) but keep leverage low, anything more than 2 times and you will be in for a ride you just won't enjoy. Keep it slow, steady and risk averse; that is always the answer to profitable trading.

Charles Fitzgerald is a finance professional and owner of The Kewl Shop:

The Kewl Shop is really just that. A place to find stuff that you always knew you wanted, but didn't know exactly what it was or exactly where to get it. Buy something from The Kewl Shop today and I'll send you a free baseball cap or T-shirt, just drop me a note from the check out cart with your size and preference and I'll add it to your order for free!

The Kewl Shop now stocks some of the best trading books available:

Source: EzineArticles
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