Leverage, It’s Personal

Boris Schlossberg

Did you know that in US capital markets options flow is now nearly equal to the underlying flow? As early as 2016 it was just 30% of equity volume. That suggests that the lever factor in the US market may be far higher than anyone imagined since stocks can only be levered 2:1 while options are a defacto 10:1 bet.

Leverage is all around us but it is poorly understood. In FX, for example, you can achieve leverage as high as 400:1 in some jurisdictions and even the most regulated places in the world like Hong Kong, Japan, EU and US offer margin of between 25:1 and 50:1.

Most retail traders, however, confuse the concept of margin and leverage. Margin is the maximum amount of credit that your broker will extend to you. So at 100:1 margin, you can actually trade a 1M EURUSD position with as little as $1000 in your account.

So 100:1 margin is the possibility of trading a Million EURUSD position with very little actual cash. But no one is forcing you to do that. No one is putting a gun to your head. You can for example just trade a 1000 EURUSD position employing no leverage at all.

Margin is what the broker offers you. Leverage is what you choose to take.

What’s the right amount of leverage?

I have no idea. Leverage is a very personal thing and it can vary not just by the trader but by trading instrument and strategy.

I will, however, tell you what is the wrong amount of leverage – anything above 10:1. That may seem extremely modest especially for those of you who trade FX, but I can assure that anything above that number will wipe out your account eventually and often much faster than you think.

Why? Because when most retail traders think about leverage they are thinking in terms of an opening bet. Suppose you have a $10000 account and you decide to trade 10:1. You open up 100K EURUSD trade. A few hours later you may see a setup in AUDJPY and then in EURNZD and then in EURJPY and so on and so on. Soon you have five trades and 500K of open positions subject to market risk and are effectively trading at 50:1 leverage. If all five trades get stopped out for 1% and you just lost 50% of your account. It’s the easiest money the casino – err I mean your broker – ever makes. They don’t have to manipulate prices you are perfectly capable of bankrupting yourself.

So leverage is very personal and perhaps we should ask the question a different way. What’s the minimum amount of money you need to make a minimum bet in the market?

As some of you know after decades of inactivity I started trading US stock index futures again. I am trading the new e-mini micro contracts which have day trading margins of as little as $50 per contract and overnight margins of about $700. For all practical purposes, you only need $1000 to trade the product yet I trade with $5000 per one contract. Why? Because I know myself. My opening bet is never my only bet. I will sometimes average out into position. I will at times increase size depending on the price action at hand. I will sometimes take the same setup in two similar instruments like the SP500 and the Dow which is an effective doubling of the position on the same side of the market.

Having a $5000 buffer per one tiny e-micro contract gives me the flexibility – both emotional and financial to control the worst of my impulses and stay within the relative bounds of my trading plan. In my first month of trading Sniper, I made a little more than 10% on my account, but I would never have been able to achieve that if I didn’t understand my personal leverage ratio.

Hidden Leverage That Will Kill Every Day Trader

Boris Schlossberg

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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.