Understanding Leverage

This article originally appeared in the September 21, 2006 edition of Tradersmedia’s TraderSavvy Newsletter as “My Super Secret Trading Technique – Part I.”

Throughout my professional career, I have taught trading seminars and webinars, written newsletters and advisories, and generally spoken to a lot of people about trading. The most common topics people want to discuss are what indicators do I use and how do I time an entry. While these are important things to consider, they are not actually the end all and be all of trading. Probably the least common question is the question that I feel is most important: what about money management and risk?

Now, I know everyone wants the key to the vault, the one thing that is going to either turn around a losing attempt at trading or make a good method great. But that key is not a special stochastic or a custom flim-flam indicator. It is knowledge, and knowledge is power. You will never know it all about trading. No one does. But trading, as a zero sum game, is about knowing more than the next guy, especially the guy on the other side of your trade.

So how does money management fit into all of this? As I stated in the beginning, it is the least discussed topic in trading, yet it is the most important. And if it is the least discussed topic, but it is the most important, understanding this can give you an edge.

The number one reason that traders fail is not that they don’t have a winning approach, or that they did not time their entries right. The number one reason traders fail is that they lack money management. Whether you are a short term day trader or a long term trend follower, inability to understand money management as it applies to trading is a recipe for disaster.

If it is the most common problem, then why don’t more traders focus on it?

Here is a homework assignment for you, and it’s an easy one. Take a trip to the Barnes & Noble or Borders or whatever mega-bookstore you have in your town. Go to the section that has books on trading and investing. Try to find just one with money management in the title. Try to find more than five that have that as a main topic. Oh, you will find a great many like How to Quit Your Job and Become a Day Trader or Why Do You Trade Stocks When Options Are So Easy and I will grant you that many of these cover some type of rudimentary money management. But it is usually relegated to the back of the book and probably comprises a single chapter somewhere after the fat section of idealized and optimized trading examples.

The fact is money management is not sexy. It does not have marketing sizzle. It does not sell books or trading courses. It is, however, the single most important topic you will study if you are to be a successful trader. Remember the old adage Preservation of Capital? That’s money management, my friend.

If you are still reading, you are a dedicated soul. I am quite certain that the majority of readers have moved on to something else already. Now the question is, “What are your money management techniques?” The answer certainly cannot be summed up in a single chapter, but we can begin to cover some concepts that should help you. Before we can discuss money management, we have to fully grasp the concept of risk, because these two things go hand in hand.

I am certain that everyone has, at some point, seen the disclaimer “There is Risk of Loss in Trading.” That goes for futures, options, or forward contracts on widgets. If you enter a trade, you have the potential to lose money.

Take that to the next level. There is risk of loss the minute someone puts a dollar bill in your hand. If you do nothing with your money but hold onto cash you could lose it, or your house could burn down. Uninvested, you have risk that your money will lose value over time. Invest in CDs or place it in an insured savings account and the risk is that it won’t keep pace with inflation or rates will be lower when the CD comes due. You can do your own extrapolation and see that the minute that dollar enters your possession, you have some type of risk.

I assume that most of this audience is comfortable with some degree of risk; otherwise, you would not be reading about trading. But the number one objection that I hear to trading futures is that they are so risky. “My brother-in-law’s neighbor had an uncle who lost his house trading soybeans.” True, leverage can hurt you. But did you know that you can manage your degree of leverage?

There is a minimum margin requirement in every trade, but there is no maximum. To reduce exposure to risk, reduce your leverage by applying more of the face value of the contract to the trade. Here is an example:

If corn is averaging $3.50 a bushel, then a 5000 bushel contract has a total value of $17,500, but the margin requirement is only $1350. That is only 7.7% of the contract value. That is a lot of leverage. Market regulations require that you put up at least $1350 per contract. But no one says you can’t put up more. Let us assume that you put up half the contract value – $8750. Corn would have to go to $1.75 per bushel for your account to turn negative, but with $1350 in margin, at $3.22 bushel you are in the hole. On the short side, with 50% of the contract as margin, corn has to go to $5.25, but only $3.78 for your account to turn debit if you are using minimum margin as a rule.

Now understand that when you apply more toward the contract and reduce your leverage, you are reducing the amount of return on invested capital. A 10¢ move in corn is a much bigger percentage of minimum margin than it is on full contact value. This brings up another interesting point. The conventional “wisdom” (and I use that term lightly) is that commodities are more volatile than stocks. But I would argue that that is an incorrect assumption.

Grasping this concept is, in my opinion, critical to understanding risk management. If you can understand that you are starting to see key points of money management. Choosing the number of contracts, or position size, is critical to success. This is the boring part of trading education, but it is fundamental to success. You are to be commended for coming this far. As Tim Robbins’ character, Andy Dufresne, says in The Shawshank Redemption, “If you’ve come this far, perhaps you are willing to go a little farther.” In the following section, I will discuss money management in terms of determining position size and how to build a money management strategy to fit your objectives and risk tolerance.

The risk of loss in trading commodity futures and options can be substantial. Before trading, you should carefully consider your financial position to determine if futures trading is appropriate. When trading futures and/or options, it is possible to lose more than the full value of your account. All funds committed should be risk capital. Past performance is not necessarily indicative of future results.

The content of this article is Copyright © 2007 by Chad Butler. No part of this article may be reproduced in whole or in part without express written permission of the author.