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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.