Applying Money Management Systems with Leverage

Discussion in 'Trading' started by Echieo, Dec 2, 2008.

  1. Echieo


    I was curious how people apply money managment systems when heavily leveraged and day trading. I typically swing trade and rarely trade with leverage. When I do leverage it is in very small amounts. I manage risk by determining a logical stop and then calculating the number of shares to buy to ensure that if i'm stopped out I will not loose more then 2% of my account on the trade. How does one do this with a heavily leveraged account? I imagine a single trade with high leverage could pose a serious risk to your entire account unless you set your stops very close to your entry points (which isn't always practical).
  2. ronblack


    No, this is wrong, leverage should affect neither your stop price nor your target price but only your capitalization. It is the number of shares/contracts that could change in the presense of leverage but not necessarily so.

    The number of shares/contracts is equal to N = PR X C/SL, where PR is the percent risk per trade, for example 0.02 for 2%, C is the available cash and SL the loss in case the stop loss is hit. In the formula you must use the value of the cash account.

    The leverage determines the maximum shares/contracts you can buy or sell as follows

    Nmax = C x L / P where P is the price, C is the available cash and L is the leverage.

    If N > Nmax, then set N = Nmax and that only has the effect of lowering your risk to

    PR' = Nmax x SL /C which is < PR

    For example if you trade equities and you have 10K in the account and the leverage factor is 4, your percent risk is 2%, or 0.02, and the stop loss value is $1 then

    N = 10,000 x 0.02/1 = 200 shares. Simply, if you lose $1 per share you lose a total of $200 which is equal to 2% of your account.

    The maximum number of shares you can buy on leverage is:

    Nmax = 10K x 4 /P,

    If P = $100 then Nmax = 400 and you can trade the 200 shares. But if P = $300 (something like GOOG*), then Nmax = 133.33 and you can only trade that much because you are limited by your account capitalization for that particular trade.

    In case of short equities you should also take into account other regulations for capitalization.

    The derivation of the position sizing formula for percent risk can be found in this paper by Michael Harris, which I recommend you read:

    * of course, you wouldn't place a $1 stop in GOOG, this is just an example to illustrate the formula use.
  3. Echieo


    Thanks for the info and the link. So basically, the advantage leverage gives you is that you can be in more trades, or bigger trades then your account would otherwise allow. Why do people get so excited about getting high leverage then? It seems that with a lot of trades my MM system tells me to spend less, not more.
  4. The paper and this thread is extremely humorous.

    What is being pointed out is that not knowing what you are doing need not be dealt with. Just do not use any capital in the markets and, regarding leverage, don't bother learning what its purpose is.

    The sypathetic basis of the conventional wisdom of the financial industry has been known and available for centuries at this point.

    To paraphrase: " WE would all like to give you some math for dealing in markets, BUT to do so we have to snuff out the goal of trading (to make money) by using timing to optimize profits, profit segment by segment."

    John Netto wrote a book, "One Shot, One Kill". He was almost a high school drop out who went into the Marines and learned to be a sharpshooter. Then he learned Chinese and Japanese while guarding the embassy in Japan. And he moved to Vegas when his duty cycle ended.

    Used copies of his book sell for more than the original price.

    You may recognize the name; he sets the line in Vegas for college football.

    He also plays at the big poker tables as a hobby. There is no question that he can afford it at all. He plays to win.

    He laughs a lot when he is on a panel at an Expo. The panel title is: "Great Traders You Have Never Heard Of". One of his funniest gestures when a meek GS guy is pontificating on a "situation" like you are, is to use both hands to push the pile of chips into the center of the table.

    Skill and knowledge in trading is to "know that you know". The market "TELLS".

    Money management does have indicators. They are used to explain how many times the capacity of the market you can "go in with" as you carve the turns at price movement extremes.

    Well after "One Shot, One Kill" comes the automatic repeater of repeated partial fills at market capacity while fully leveraged.

    Imagine it for a minute or two.

    Money management mathematics is non-probabilistic partial differentials as a function of time. Making money and its timing is on the horizontal axis.