Leverage is a wonderful thing. It’s what allows businesses to grow and flourish at a rapid pace. It’s what allows traders to grow their account much faster than without it. However, too much leverage is deadly and can ruin you if you misuse it. Here’s a guide to assessing how much leverage is suitable for you, if any.
What Is Leverage?
Leverage is essentially borrowing money to make larger purchases. In other words, when you purchase a house with 20% paid for in cash and the other 80% is mortgaged, you are using leverage.
In the context of trading, you can trade Stocks, Futures, and Options on margin. The margin is the small portion of collateral that you put up to trade, while your broker fronts you the rest.
If your position goes against you, your broker will close you out of your position if your margin gets eaten up unless you add more margin. Conversely, you get to keep the amplified gains if your position moves in your favor.
How Do You Measure Leverage?
In trading, you simply take the total notional value of the instrument your trading and divide it by the margin you put up. For instance:
- The /ES is trading at around 2,570
- Each 1 point move is worth $50
- To convert the point value of 2,570 to USD you multiply it by $50
- $50 x 2570 = $128,500
- $128,500 is the Notional Value of the /ES
- If you put up $5,000 in margin, you would be leveraged 25.7x
- If you put up $500 in margin, you would be leveraged 257x
Risk of Ruin
This is the most important concept to understand when it comes to leverage and successful trading. The Risk of Ruin is the probability of losing all of your money. In the financial markets, money is how you get to play the game. No money, and you don’t get to play anymore.
That’s no fun. So it’s important to realize that you will naturally occur loses as a part of the game, you need to protect yourself from losing so much that you are ruined and knocked entirely out of the game.
If you would like to calculate your Risk of Ruin, here’s a really useful Risk of Ruin Calculator that can do it for you. It essentially takes your win ratio (be sure to track your trades) and how much you lose on average versus how much you win on average.
The concept behind Risk of Ruin can be applied to professional gambling as well as trading. Here’s a video that explains this concept further.
Leverage And Debt Are The Same
As Robert Kiyosaki and many others have said, there’s good debt and there’s bad debt. Good debt is the debt (leverage) used to purchase assets that will pay you back and produce cash flow.
Bad debt is like credit card debt. It’s the debt that does nothing to pay you back.
You see good debt/leverage is used to amplify gains. If you expect to make 8% on an investment over the course of the year and leverage it by 3x, then your expected gain will be about 24% (8 x 3 = 24).
Good debt will amplify your investment returns. Bad debt will take money out of your pocket every month.
Don’t Wind Up Like Kenny
There are a lot of brokerage firms that will let you day trade futures on $500 worth of margin. If my friend came up to me and told me he was day trading futures on $500 worth of margin, I would slap him upside the head. There is probably nothing more dumb than day trading futures on $500 worth of margin.
Look back at our example on calculating leverage.
With the /ES currently trading at around 2570, $500 in margin means you’re using 257x in leverage. This means that every 1% move in the price of the /ES (25.75 points) will result in a 257% move in your account.
This is great if you’re on the right side of the trade. This will kill your account if you’re not.
With 257x, your Risk of Ruin is way too high for you to recover from any adverse moves in your account, and you will have adverse moves in your account. That’s just a part of the game.
How To Avoid Being Like Kenny
It really comes down to your own trading style. If you have a very low win ratio on your trades, then you will likely want to stay away from a lot of leverage. Moreover, if you lose a lot on your losers relative to your winners, then you will also want to stay away from a lot of leverage.
Let me put it this way…
The classic definition of a Bear Market is when a Stock/Future declines 20% from its all-time high. If you leveraged your account by 5x relative to the notional value of the instrument you’re trading, then a 20% decline in the Stock/Future would result in a 100% decline in your account.
That may seem pretty scary. However, when you consider the odds around the expected move each day in a Stock/Future, the odds that you hold through a 20% decline are very slim.
I’m not giving advice here by the way, just a perspective.
Volatility And Leverage
These two concepts go hand in hand with the importance of Risk of Ruin. Let’s go back to the /ES example:
- The /ES has been moving about 0.60% lately (on a good day)
- If you buy 1 /ES contract, and use no leverage, your account will fluctuate ± 0.60%
- If you use 5x leverage, you should expect your account to fluctuate ± 3.00%
- If you use 10x leverage, you should expect your account to fluctuate ± 6.00%
With something like the /NQ that can move around ± 1% a day, the same returns would apply with how much leverage you use. The only difference between the /ES and /NQ is the volatility and liquidity.
Does this mean that you should trade the /NQ because it’s more volatile, and thus you have the opportunity to make more? Not really. It depends on your personality, appetite for risk, and how quick you like your instrument to trade.
The /NQ’s tend to be a lot faster in terms of trading tempo than the /ES. So, if you have a slower demeanor, then maybe the /NQ’s aren’t for you and the /ES would be better.
That’s the great thing about trading… it’s your choice.
Less Leverage = You Make More Money [Probably]
I actually wouldn’t say “probably”. I would say “definitely”. Let’s not forget the emotional toll that trading/investing can take. The less amount of leverage you use, the less stressed out about a position you will be.
As a result of being less stressed, you will think more clearly and make better decisions.
Conclusion and Takeaways
Leverage is great. It can take a small account and turn it into a larger one much faster. But whether it be in trading or real estate, too much of it will destroy you. Don’t wind up like Kenny and over-leverage yourself. Find the right amount of leverage (if any) that suits your trading style, and stick to that.
Moreover, more volatile instruments remove the need to be highly levered by the mere fact that the leverage amplifies the volatility. If you’re trading Crude Oil (which moves around 2% a day) and are levered up 10x, would you be comfortable with 20% swings in your equity curve?
Anyhow, I hope this article was helpful. Let us know what you think in the comments below. Thanks.