John has traded just about everything an individual trader is likely to trade. He has worked as an analyst in the equity, foreign exchange, fixed income, and energy markets, and has published literally dozens of articles on market analysis and trading methods.
Here is Mr. Forman’s take on leverage:
I’ve been involved in a discussion recently on the topic of leverage. The question that started it all basically was “What leverage ratio should I use?” This came from a forex trader, but could certainly just as easily have come from a futures trader as well (or even a stock trader in some cases).
If you’ve ever wondered that same thing, you are asking the wrong question. Any position you take in the markets should start first with the question of how much risk you are going to take on that trade. There are a variety of different approaches to that, and I won’t get that discussion going here. For the sake of things right now, let’s just assume you’ve decided it will be $500.
Now consider the trade you are thinking about making. You should have some idea of what the point/pip risk is going to be on the trade. Translate that in to a dollar value on a per trading unit basis (contract, lot, etc.). That leaves you with three basic scenarios:
More than your acceptable risk
In this situation you find that the reasonable risk on the trade is more than what you have defined as your cut-off ($500). If that is true, there is only one course of action. Walk away. Another trade will come along. Don’t take on a trade that is riskier than what you have defined in your trading plan.
At or close to your acceptable risk
If you find that the per unit risk is close to your $500 risk target figure, put on a one unit trade. Very simple.
Below your acceptable risk
Should you discover the per unit risk for the trade you are looking at is well below your $500 limit, you can take on a bigger trade. For example, if the risk is $125/unit, do a four unit trade.
The leverage part comes in to the equation at this stage. The question becomes how much leverage do you need to use to take on the position size you have determined going through the process above.
Let’s look at things in terms of a trading unit being $100,000 in value to keep the numbers round, and that you have a $10,000 account. Throwing out the situation above where the trade risk is higher than your $500 cut-off, we are left with two situations.
In the case where the per unit risk is at or near your allowable risk, you put on the one unit trade. That means taking a $100,000 position, so you would employ 10:1 leverage. If, however, you are in the third situation where the per unit risk is $125 you can put on a four unit trade. That means a $400,000 total value trade. This is 40:1 leverage. (Note: margin requirements for forex and futures trading is often 2% or less, meaning 50:1 leverage or higher.)
Do you see how this process reverses the way you think things through?
So the real answer to the question of how much leverage to use is “the amount that allows you to trade the position size that matches your allowable per trade risk.”
John Addresses Leverage Influencing Your Trade Size:
The question “How should the size of your leverage influence the size of your trades?” was recently asked.
Leverage and margin is something that can really get the head of a new trader spinning. The easiest thing to do is to take it out of the equation in your position size decision-making process other than to determine how large a trade you can put on. Maximum trade size available is really the only thing leverage means to you. Aside from that, it doesn’t matter at all.
When you decide on trade size it should come completely from your risk plan. You should know what your permissible risk is. You have an idea of what your risk is on a given trade. You adjust your trade size to make the two match. If the trade risk exceeds your guidelines, you don’t take the trade. If it’s not, you take the size position your parameters allow, up to the maximum size your leverage will permit.
That’s it. Real simple.
Mr. Forman’s Further Definition of Leverage:
I brought up the topic of leverage a couple months ago in my post How much leverage to use? Wrong question! The general topic of leverage, though, continues to be much misunderstood, so let me take some time to back it down to the basics.
Leverage the control of a position larger than your own funds would directly allow. It’s available in one form or another in basically every market and is accomplished either through borrowing and/or the use of derivatives.
You will see things like 50:1 leverage or 100:1 leverage. A 100:1 leverage ratio means that for every $100 in position value you would be required to put up $1 in deposited funds.
Now margin is closely tied to leverage. Margin is the deposit money used to secure a leveraged position. It is normally expressed in percentages. For example the margin on a position when employing 100:1 leverage would be 1%. At 50:1 leverage it would be 2%. An so on.
There is the additional topic of gearing or effective leverage or real leverage. Those are just different ways of talking about the actual leverage one employs when holding a position. For example, you may be able to trade at 100:1 leverage but if you have a $10,000 account and are trading a $100,000 position you are actually only using 10:1 leverage – meaning your are only controlling a trade 10 times the size of your account.
I think most people get that part of it all.
Here’s where the confusion comes in. I have seen a number of traders say that leverage equals risk. This simply isn’t true. What is boils down to is this. Allowable leverage tells you one thing – how big you can trade, either in terms of position size or number of positions. That’s it. No more. No less.
Risk comes down to one thing, and one thing only – the size of your position. The larger the position, the greater the risk. It’s that simple, really. High degrees of available leverage certainly allow for larger positions, but they do no require them.
The thing that I think causes the most confusion is thinking in terms of margin and not account size. If you trade at 100:1 leverage you would have to put up 1% margin. That means a 1% move in the market against you would wipe out your margin deposit. If you were trading on 50:1 leverage the same 1% move against your trade would only take out half your margin. That seems like less risk.
Here’s why it isn’t.
Assume a $10,000 account and a $100,000 trade size. For a 100:1 leverage account the margin requirement would be $1000, while at 50:1 it would be $2000. If the market moves against the position by 1%, that would mean a $1000 loss to the account, or a 10% decline in account value. It doesn’t matter whether the trade was done in a 100:1 or 50:1 leverage account. A 1% move on a $100,000 position will always represent a 10% change in account value for a $10,000 account.
The only time differences in leverage mean differences in risk is when you are talking about different position sizes, basically meaning using all available funds for margin. The 100:1 leverage $10,000 account could take $1 million, while the 50:1 could only go as high as $500,000. Clearly, when the accounts are maxed out like that a 1% move in position value is different. The 100:1 account would be wiped out, while the 50:1 account would only lose have its value.
I hope that clarifies things a bit. Feel free to comment with your own thoughts and/or questions.
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We also compiled the Q&A format for leverage and its risk below:
Gearing and Leverage
Q.: What is gearing (or leverage)?
A: Hedge funds use it, so do a number of exchange-traded and investment funds. Daytraders and Prop Traders (Props) do too. Leverage (or gearing as it is sometimes referred to) is much like borrowing: it allows you to increase your potential return on a trade as you increase your exposure to the market.
Gearing, as in the mechanical sense, is the process of turning a medium effort into a large output (examples: in a lever or in a bicycle's gears. In financial terms gearing has the same effect: it enables a customer to trade a position in much larger size than the margin that is deposited with the Prop Clearing Firm, e.g. For an initial deposit of $5,000, a customer can buy or sell $50,000 of qualifying securities (This is 'gearing' or leverage of 10:1). Gearing when used this way is also sometimes referred to as investment gearing.
Gearing, as in the mechanical sense, is the process of turning a medium effort into a large output (examples: in a lever or in a bicycle's gears. In financial terms gearing has the same effect: it enables a customer to trade a position in much larger size than the margin that is deposited with the Prop Clearing Firm, e.g. For an initial deposit of $5,000, a customer can buy or sell $50,000 of qualifying securities (This is 'gearing' or leverage of 10:1). Gearing when used this way is also sometimes referred to as investment gearing.
Leverage is the ability to trade a large position (i.e. a large number of shares, or contracts) with only a medium amount of trading capital (i.e. margin).
Props allow you to speculate on rises and falls in stocks, currency pairs and other assets while only putting up a medium amount of your own money. You are leveraging off the money you do have, in the hope of making more. Gearing (another word for leverage) in Props enables traders with a medium float to make good profits from trading the stock market. In other words, gearing or leverage magnifies investment returns and can even help you diversify a trading portfolio as it frees up capital which can then be deployed in other investments. For instance your trading system might be designed to make a 25% return per annum. With a $5000 float, this would produce $1500 in profit in one year. However with Props because of the gearing the same system could potentially make a 300% return, which would be $15 000 profit in one year. But it is important to understand that gearing (leverage) is a double-edged sword and an asset can fall as well as rise thereby potentially magnifying your losses.
Account Value | Margin | Leverage factor | Maximum Exposure |
$10,000 | 5% | 20:1 | $200,000 |
$10,000 | 10% | 10:1 | $100,000 |
$10,000 | 20% | 5:1 | $50,000 |
$10,000 | 50% | 2:1 | $20,000 |
With Props , you only have to put in a fraction of the market value of the underlying asset when making a trade, sometimes as little as 5%. The remaining 95% of the value of the asset is covered by the PROP provider. Despite only outlaying a fraction of the face-value of a trade, the PROP trader's account balance will still reflect the financial impact of movements for or against the full sized position. In other words, even though you originally only put up 5% of the value of the market position, you are still entitled to the same gains or losses as if you had paid 100%. This is great if prices move in the anticipated direction. If trading a share on a margin of 5%, a price rise of 1% in the underlying market could deliver gains of 20% on a long PROP position. However, if prices moved against the PROP position by 1%, it could result in a loss of 20% of the amount initially outlaid as margin. If PROP traders overlook this feature of trading on margin, they risk making the mistake of taking on too much risk.
Q.: Is leverage good or bad?
A: Leverage represents an efficient way to use trading capital and many professional traders value this investment property precisely because it empowers them to trade larger positions (more contracts, stocks..etc) with less trading capital. Leverage by itself does not change the potential profit or loss on a trade. What it does is to reduce the amount of trading capital that must be tied to open trading positions, releasing trading capital which can be utilised for other trades in the process. For instance, a PROP trader that wanted to buy 1000 shares of stock at $25 per share would only need perhaps $2500 of trading capital (10% margin requirement), leaving $20,000 available to open additional trades. That's the way professional traders look at leverage.
It is also worth nothing that in addition to being an efficient use of trading capital, gearing or leverage can also help reduce the total amount at risk for certain types of trades. For instance, a trader that wanted to invest in 10,000 shares at $10 per share would need $100,000 to have this exposure in a traditional shares portfolio and all this would be at risk. However a trader that wanted this exact exposure in the same share with exactly the same potential upside or loss (i.e. a tick value of $100 per 0.01 change in price) using the warrants markets might only need a fraction of this amount, say, $5,000 and only this amount would be at risk. Another aspect worth noting is that leverage allows for greater diversification as it allows you to open multiple positions across different assets with a limited amount of capital (as opposed to buying only one share).
Professional traders will choose highly leveraged markets over non-leveraged markets every time.
It is also worth nothing that in addition to being an efficient use of trading capital, gearing or leverage can also help reduce the total amount at risk for certain types of trades. For instance, a trader that wanted to invest in 10,000 shares at $10 per share would need $100,000 to have this exposure in a traditional shares portfolio and all this would be at risk. However a trader that wanted this exact exposure in the same share with exactly the same potential upside or loss (i.e. a tick value of $100 per 0.01 change in price) using the warrants markets might only need a fraction of this amount, say, $5,000 and only this amount would be at risk. Another aspect worth noting is that leverage allows for greater diversification as it allows you to open multiple positions across different assets with a limited amount of capital (as opposed to buying only one share).
Professional traders will choose highly leveraged markets over non-leveraged markets every time.
Leverage make Props very attractive as a trading product. But because you are trading with leverage, the gains and losses are magnified - and the risks are much greater - use leverage with care!
Q.: Do all Props have the same level of leverage, what is the leverage?
A: No, it varies widely - depending mainly on the volatility and liquidity of the underlying markets. The actual percentage of the margin (i.e. market value) that you will be requested to put in will also vary for different PROP providers. The main variance is the underlying assets securing the leverage.
In practice, initial margins can range from as low as 1% to as high as 75% depending on the specific instrument. Most share Props in the ASX 300 and FTSE 100 are around the 5% or 10% mark whereas for medium caps the initial margin requirementd would more likely to be in the 25% to 50% range. If you are looking at foreign exchange then you can get much higher levels of gearing (normally starting at just 1%) simply because stocks are much more volatile whereas a currency moving high in value in a short-time period is relatively unlikely; although it has happened recently with a number of currency pairs so it very much depends on the product that you are trading. Likewise for the indices margins start at 1% of the overall exposure. A number of PROP providers also use a margin-based system wherby the margin required would depend on the stop loss level; so while a trader buying one PROP on the Dow might normally have to put up $350 as margin, the margin required for this same position would go down to just $100 if a 100-point stop loss is built into the position.
Q.: Just wondering what the effect is in comparison to medium leverage say 3/1 and then more 5/1 10/1 and more.
How does it effect your position in trades? Also, what the difference is in how one reacts to the high gearing situation, much more risk I know.
A: In forex, if you are using 1:1 leverage , and your trade moves 3%, your account will go up or down 3%. With 5:1 leverage , when your trade moves 3%, your account will change 15%. With 10:1 leverage, your account will change 30%.
If you do not want to use leverage and only want to use 1:1 then your position size should not exceed than what the balance of your account is. For instance if you have an account balance of $10,000 and you make a trade for $10,000 then you are not leveraged.
The way high gearing effects traders is the emotional reaction a trader has because such a large percentage of their account is on the line. Greed and fear are the usual reactions.
How this applies to the technical aspect of the trade is that to follow proper money management , you will be forced to really tighten your stops. Higher gearing (i.e. leverage) means a bigger position size. Which follows that to keep your maximum loss of say 2% per trade, you would need to place a really tight stop. But it is important that you do not place a stop loss just because that point is where you are not prepared to risk more money. You first need to make sure you are looking for a support level and then decide on the amount of money you are willing to risk or lose if you make it to that level and lastly set your share size accordingly. Make sure you don't just pick a spot and say 'well here I will be losing $500 so I need to make that my stop loss '.
If you do not want to use leverage and only want to use 1:1 then your position size should not exceed than what the balance of your account is. For instance if you have an account balance of $10,000 and you make a trade for $10,000 then you are not leveraged.
The way high gearing effects traders is the emotional reaction a trader has because such a large percentage of their account is on the line. Greed and fear are the usual reactions.
How this applies to the technical aspect of the trade is that to follow proper money management , you will be forced to really tighten your stops. Higher gearing (i.e. leverage) means a bigger position size. Which follows that to keep your maximum loss of say 2% per trade, you would need to place a really tight stop. But it is important that you do not place a stop loss just because that point is where you are not prepared to risk more money. You first need to make sure you are looking for a support level and then decide on the amount of money you are willing to risk or lose if you make it to that level and lastly set your share size accordingly. Make sure you don't just pick a spot and say 'well here I will be losing $500 so I need to make that my stop loss '.
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