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The Power of Leverage

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Using leverage improperly increases risk rather than lowering it.

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In the financial markets, successful speculation boils down to a few factors that, although not easy to attain, are quite simple. Those factors are low risk, high probability, and a reasonable degree of leverage. The fact is, most people that first engage the markets -- that is, those that don't have any idea how the financial markets work -- look at these critical factors of successful speculation in the entirely wrong sequence.

First, the lure of easy money leads them to buy "cheap" assets, such as penny stocks, or far out-of-the-money options, which are highly leveraged. They require little money to purchase, and if the trades work, they will produce big payouts. The odds of these trades working out, however, are remote; they have a low probability of success. They also -- as I mentioned earlier -- usually cost a small sum of money, and a trader may risk his or her money and investment. This in turn makes this trade high risk. Isn't this scenario similar to the gambler who goes to Las Vegas, knowing full well he's likely going to lose, and usually does, but loses more than he initially planned?

So to sum it up, a novice trader uses maximum leverage in the trades that have the lowest probability and the highest risk. Mathematically, this flies in the face of what a trader should be doing to profit consistently. The math works better when taking the lowest risk, the highest probability, and moderate leverage.

In the general public's view, using leverage in trading usually gets a bad rap. Almost everyone has heard about leverage, or personally experienced large losses at the hands of leveraged assets, such as options, futures, or forex. Many of the large brokerage firms go as far as requiring their clients to have several years of trading experience before they will allow them to use margin. This is due to the risk associated with leverage. Firms wish to protect themselves more than they protect clients. This may not come as a surprise, but on Wall Street, companies and individuals look out for their own interests, even at the expense of others.

Leverage, when used judicially, is a beautiful thing. Real estate is a great example of an investment in which leverage used smartly works well. It's rare to see a first-time homebuyer purchase a house without the assistance of financing. This use of leverage has helped many people buy homes who would otherwise have been excluded. More importantly, if purchased in the right market, the equity generated through the appreciation of the property enables the homeowner to move to a bigger home or another investment property. The media has deemed this "the American dream," and it is made possible only by using leverage in a sensible manner.

The futures market is very similar, in that a trader has the benefit of ten-to-one leverage on most contracts that trade on major exchanges. Similar to leverage in real estate, when traders buy a futures contract, traders "control" a sizable amount of the underlying cash asset (this could be an index, currency, or physical commodity) for a small deposit referred to as a performance bond. This bond acts as collateral for controlling the asset.

The key when using leverage is to find the lowest risk opportunities so that if traders err, they lose little. The chart below illustrates one of these low risk opportunities that presented itself in the Russell 2000 E-mini contract recently. The setup was simply to buy at demand with a limit order at the top of the demand zone, and placing a stop a few ticks below the lower line of that same zone. We also used the opposing supply zone for a target.



In this trade example, $1320 is the intraday margin that controls approximately $96,000 worth of the Russell 2000 Index (INDEXRUSSELL:RUT). For traders wishing to hold overnight positions, the margin is slightly higher (about $5000). The key to using this type of leverage is that the risk on this trade was only $100 per contract. In addition, the profit margin was at least five-to-one.

As we can see from this example, low risk and high probability, coupled with prudent leverage use, add to a winning combination. However, if a trader uses these three factors in the wrong sequence, that is using leverage with high risk and low probability, well… that usually spells disaster, and nobody wants that.

Editor's note: This story by Gabe Velazquez originally appeared on Online Trading Academy.

To read more from Online Trading Academy, see:

Where Are Banks Buying and Selling in the Forex Market?

My Spread Moved, How Much Did I Make?

Happy Days Are Here Again
No positions in stocks mentioned.
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