Leverage is the ability to control a large quantity of an asset with a relatively small initial capital outlay.
A real-world example of financial leverage is the purchase of a home using a fractional downpayment and a larger financed balance. While the homebuyer is technically bound by the eventual payoff of the mortgage, only a much smaller down payment is required to secure the deal.
As a result, the new homeowner has taken a long position in the local real estate market, effectively controlling an asset that is worth much more than the initial cash investment.
Effective leverage is the amount of equity being used in relation to the aggregate value of an open position. Using the home purchase example, assuming a 20% down payment and a £330,000 sale price, effective leverage is calculated as follows:
Effective Leverage = Total Position Size / Account Equity
Effective Leverage = (£330,000/(.20 * £330,000)) = 5
The effective leverage of the home purchase is an illustration of the amount of equity used to control the value of the entire investment, in this case a ratio of 5:1.
The active trade of currencies, futures or equities function in a similar manner to a home purchase. However, the use of liquid cash as the primary means of settlement emphasizes the concept of effective leverage. As an illustration of its impact upon a forex trade, take the following scenarios:
Trader A has an account balance of £10,000 and decides to short 20 standard lots of the EUR/USD:
Effective leverage= (20 * £100,000)/£10,000 = 200:1
Trader B decides to short 20 mini lots of EUR/USD, using the same £10,000 account balance:
Effective leverage= (20 * £10,000)/£10,000 = 20:1
The effective leverage of Trader A's account is 200:1, while Trader B's is 20:1. The difference in leverage greatly increases the value of each pip, which in-turn magnifies the impact of short-term volatility. While Trader A stands to realise a profit 10 times greater than Trader B from a positive move, a negative move is detrimental 10 fold.
Fortunately, there are constraints placed on position sizing and the degree by which leverage may be implemented in the markets of futures, currencies and equities. Margin and maximum leverage requirements address the terms by which traders and investors are able to access credit within the marketplace:
Margin trading takes place when a buyer or seller places a percentage of an underlying asset's value down and borrows the balance from a broker. For instance, if an energy futures trader is interested in purchasing 1 contract of WTI crude oil (1,000 barrels) at a price of £50 per barrel, the contract is worth £50,000. In order to facilitate the trade, a broker will require a specified percentage of the contract's value to remain in the client's trading account. The balance insures the broker from taking a loss on the trade, placing the financial responsibility of the open position solely on the trader.
Maximum leverage is the largest customer position size allowable. For instance, in forex, common maximum leverage ratios range from 100:1 to 200:1. It is up to the individual to learn what the maximum leverage constraints are and how they will be applied to the trading account.
In the realm of active trading, risk management is a discipline essential to sustaining profitability. If the issue of risk is not thoroughly addressed before entering the marketplace, unexpected volatilities can wreak havoc upon the trading account. It is imperative that risk is put into the proper context each and every time an order is placed at market.
Depending upon the type of trading and market being engaged, your approach to risk management may vary. However, there are four basic actions that can be extremely useful in limiting risk exposure:
Adherence to a comprehensive trading plan
Use of protective stops and profit targets
Aligning risk to reward
Prudently utilising leverage
No matter if you're trading futures, forex or stocks, the number-one reason a majority of traders are forced to leave the market is untimely capital loss. Through taking an aggressive stance toward risk management, the odds of blowing out the trading account fall dramatically.
Developing A Comprehensive Trading Plan
A robust trading plan addresses several elements essential to conducting operations in a regimented manner. The following questions must be answered thoroughly while in the process of building a rules-based approach to the markets:
Strategy:Is the adopted methodology rooted in technical or fundamental analysis? Is a swing, day, or intraday time frame most desirable? Is the strategy automated or discretionary?
Ideal Market(s):Which products offer optimal levels of liquidity and volatility for the selected strategy?
Money Management Parameters:Given the available capital resources, which safeguards are necessary to protect the account balance? What kind of trade management parameters are best suited for success?
Developing and following a suitable plan is the first step in eliminating many of the unnecessary risks associated with active trading. It must be easily understood and followed routinely in order to be effective. A comprehensive trading plan ensures the trader has the best possible chance of achieving replicable results.
Protective Stops And Profit Targets
Protective stops and profit targets are integral parts of almost any risk management approach. When used consistently and within the context of a comprehensive trading plan, stop losses and profit targets ensure that downside risk is limited while acceptable returns are locked in.
A protective stop or stop-loss is an order placed at market that runs contradictory to the direction of an open position. Protective stops are placed at a price level above active short positions (buy orders) and below open long positions (sell orders). Upon price reversing to the location of the stop loss, the open position is automatically liquidated or closed-out.
Stop-losses are one of the most valuable tools implemented by active traders to limit potential liabilities. They may be placed at market using any number of strat egies. Protective stops are typically utilised in concert with an appropriate risk/reward ratio, technical indicator or predetermined monetary value.
Profit targets are applied to lock-in or guarantee that a gain is realised from a beneficial move in pricing. Profit targets are executed in a similar fashion as stop-losses. A limit, stop-limit or stop-market order is placed at market in opposition to the open position—sells for longs and buys for shorts.
Profit targets and stop-losses play a key role in risk management. While the stop-loss limits a trade's ultimate downside, the profit target ensures that gains are realised and not given back in the wake of negative price action.
Balancing Risk and Reward, Understanding The Impact Of Leverage
The business of active traders is to frequently interact with a market, putting capital in harm's way to achieve financial gain. To accomplish this task consistently and avoid abnormal account drawdowns, risk must be properly aligned with reward.
A risk vs reward ratio is a tool used to quantify the potential return and risk exposure facing a specific trade. It may be defined in terms of currency, pips, or ticks. The setting of profit targets and stop losses are key elements in developing a risk vs reward ratio.