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Hidden Leverage That Will Kill Every Day Trader
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The more I trade the more I am convinced that the vast majority of problems arise not from faulty strategy ideas but from poor money management behavior – mainly because most traders confuse speculation with investment – an often fatal mistake when it comes your capital.
Investment is essentially the art of buying assets. The simplest and surest way to make money as an investor is to simply diversify your portfolio and dollar cost average into your positions over a very long period of time (decades). Investing works because real assets tend to appreciate as economy grows and wealth becomes a simple function of compounding that economic growth.
Speculation on the other hand has nothing to do with investing. It is the art of trading sentiment and by its very nature is bidirectional in form. Speculation also tends to revolve around assets that are price bounded such as commodities and currencies. The simplest, sharpest way to understand the difference between speculation and investing is to consider the chart of the Dow versus the chart of the GBP/USD going back to 1980. Since that time the Dow has appreciated by a factor of 16 (from 1000 to 16,000). Meanwhile sterling has basically range traded from approximately 1.0000 to 2.0000. Unless we face and end of the world scenario currencies and commodities will always range trade and will therefore be instruments for trading sentiment rather than investable assets.
So once you understand that speculation is nothing more than riding the rollercoaster of sentiment on a leveraged basis you can appreciate why trading has nothing to do with investing. First and foremost speculation requires stops because it is a bidirectional game. Even if you don’t use leverage, but find yourself on the wrong side of the carry trade and decide to hold on to your position for years, you will no doubt lose all your money through capital losses and interest payments. In investing its just opposite. You will collect dividends and bonds payments regardless of the underlying price.
So if you need stops to speculate that means you will inevitably incur losses and that means that money management is a much more important skill to master than trade entry.
This becomes even more crucial to remember when you daytrade. The more you trade the more losses you will incur. That means the only way to survive and prosper is to reduce your trade size in direct proportion to your frequency. So if you trade 10 times per day you should not risk more than 20 basis point per trade which generally means that you should be trading MAXIMUM 1 times leverage of your account per trade ( assuming you are using 20 pip stop. At 40 pip stop your max allowable leverage is .5 times you capital per trade)
The reason for such low numbers is because when you day trade, you are actually using 2 types of leverage – the normal credit that you broker gives you (up to 100 to 200 times your capital in some jurisdictions) and the leverage of turnover that you generate through multiple trades. Suppose you have 10,000 in your account and you make 10 trades per day at 10,000 units each. You have just turned over 100,000 units of currency or 10 times your capital amount in one single day. Its this hidden leverage that most retail traders completely ignore – and as with most hidden things in life – it is the one thing that can kill you.