how do YOU use margin?

Discussion in 'Trading' started by Gordon Gekko, Aug 20, 2002.

  1. <b>constant position size?</b>

    Yes, its true that maintaining a constant position size would have the effect that you state, but only if the 15% gain trade occurs BEFORE the 10% loss trade.

    In the event that the 10% loss occurs first, Trader 1 would have only 90k in their account after the 10% losing trade (and 103.5k after the 15% up trade). In the event that the 10% loss occurs first for the margin user, Trader 2 would have only 60k in their account after the 10% losing trade and could only create a 240k position on the second trade (they would again have 96k after the 15% up trade, if they committed full buying power to the second trade after the first losing trade). Constant position size trading only works if you use a fraction of the maximum acceptable buying power (or you are very lucky to have your wins come before your losses).

    <b>margin modulates risk</b>

    I agree with CalTrader's perspective that margin is a risk parameter that is gives some control over risk (and that one generally wants to minimize). I think (correct me if I'm wrong) that Eldredge's counterexample illustrates the interaction of margin as part of a money management policy. Choosing to use margin is just a position sizing decision that can work well if the wins outweigh the losses by a wide enough difference. Its very tricky stuff (mathematically, you can show that there is an optimum amount of margin for any covariance matrix of expected trading returns and that that optimum margin level can be greater than 1 in some cases).

    In any case, as tntneo points out, margin is especially dangerous in a losing streak -- a very bad loss can blow-up an overleveraged account. Swing-traders that hold overnight positions must be especially careful of margin because a vicious overnight plunge in price can wipe out an overleveraged position (or buoyant news can squeeze an overleveraged short-seller to death). I would also second Rigel's observation that even daytraders can get killed by margin if a trading halt and subsequent price move occurs before they can exit an overleveraged position. Traders (me included) think we have more control over our destinies than we actually do.

    Margin means both living on borrowed money AND borrowed time, IMHO. Sometimes its OK to borrow both time and money (but it is risky).

    Wishing safe trading to all,
    #11     Aug 20, 2002
  2. Alpha, you are talking about %increases/decreases on your TRADES. When most people talk about drawdowns and % decreases they are talking about the value of their account.

    For Swingtraders, where the risk on a position is often more than $2 or $3, I can't see how a trader could possibly go into margin on a single trade if he still wants to practice 'prudent' risk management. If you have defined where you will exit a trade if it goes against you, eg, $45 on a $50 long positition, make that $5 risk a certain percentage of your account. Eg, 2%. What 2%= depends on your account size. If you have $500,000 you could then risk $10,000 on that trade (2% of 500k), you would then buy 2000 shares. That would only cost $100,000. If you wanted to use your full 2:1 buying power, you could buy 20,000 shares, however, if you still kept a stop at $45, you would be risking 20% of your account; NOT good risk management.

    If a swingtrader takes several positions at once, it is quite conceivable that he would use margin. (I won't get into a discussion on the 'riskiness' here, save to say it would probably be better if such positions were uncorrelated.)

    Daytraders (the kinds i know) normally risk in the region of 10-50 cents per trade. As such, it is quite normal for daytraders to use the full 4:1 margin on a single position. Many (prop traders) use a lot more than that, and have multiple positions on aswell. The key factor is how much of their account they are risking; if it is within reasonable risk management parameters, there is no problem with the 'obscene' levels of margin.

    As to Rigel's suggestion that it is STILL risky (intraday margin) because a stock WILL get halted (it WILL happen to you): I'm not sure what the rules are for halting stocks, but I assume that they are only halted if they are falling. In that case the risk only exists on the long side. If a stock is falling precipitously, it is pretty dangerous to be buying it regardless of whether it'll be halted or not. (even though some people do...and make good money at it)
    #12     Aug 20, 2002
  3. Publias

    Publias Guest

    What Dan said! :D
    #13     Aug 20, 2002
  4. OK, I knew someone would catch the fact that my examples use the rather risky practice of buying a single position with the entirety of the account (should have guessed it would be you, daniel_m, as it is hard to get one past you :) ). Anyhoo, the example also works if you construct a more complex set of trades with multiple stocks that lead to a 10% drawdown and then a 15% gain off that bottom. If you replicate those trades under two money management strategies: a conservative one (using 1:1 margin or cash-only); and an aggressive one (using 4:1 margin) then you will find that trader using margin is worse-off.

    The reason for the nonlinear amplification of losses is that those evil brokers refuse to share in their trader's losses (demanding that they repay everything they borrowed + interest regardless of how badly the market behaved). Every time there is a loss in a leveraged position, it has a disproportionate effect on future buying power. Leverage puts the compounding of gains on steroids in both the good and bad direction. Thus, the old saying about having to create a 100% gain to offset a 50% drawdown is magnified by leverage. A sequence of trades that would incur a 25% drawdown in a cash-account wipes out a 4:1 leveraged account.

    Now everyone can (and should) use more complex money management strategies that I have presented in these simple examples. Risking 2%, as daniel_m suggests, seems a popular and sound risk management policy. But, unless you know ahead of time which trades are going to the losers, those losers are going to hurt more with margin borrowing, and leave one with less buying power for future winning trades. Another way of looking at this is that some trading systems that have positive expectation for cash-only trading, can have a negative expectation under margin-borrowing. I am NOT saying that all trading systems are like this. A very profitable trading system (that never suffers from excessive drawdowns) will become an insanely profitable trading system using margin borrowing. I, and others on this thread, are only cautioning about the risk amplification properties of margin borrowing -- the ability to the trader to get themselves in a very deep hole very quickly.

    I wish all of you good trading and great profits,

    P.S. RE HALTs: Although I am sure that many halts occur after a decline in stock price that might let a skilled trader exit before the halt, I suspect that some of the worst halts happen so quickly and under such an order imbalance, that most daytraders would be caught holding positions. Imagine if 9/11 had occured at 10AM, instead of before market open.
    #14     Aug 20, 2002
  5. Well, what I tried to say in my original post is that, no, margin does not have a negative impact on future buying power (as a result of losers.)

    If you are gonna risk 5% of your account, the are thousands of different ways you could do it.
    if you have $100,000 and want to risk $5000 you could:

    assume ABC is trading @$100

    buy 25,000 ABC with 20 cent stop; (VERY FEW stocks you take this many shares at the one price (and none that are priced at $100). Example just for illustrative purposes. Would also require 'professional trader' status to get this type of margin)
    buy 4000 ABC with $1.25 stop; (making full use of intraday 4:1 margin)
    buy 1000 ABC with $5 stop;( a possible multiday swing trade, using no margin)

    The point is, that whether or not margin was used, the impact on the account size is the same - using our 5% of account size risk level.

    Now, if YOUR particular trading sytle means taking a position and holding for several days, which usually means a stop of greater than $2 (depending on the stock's price and volatility), ANY use of margin would probably TOO RISKY relative to account size.

    I think that what you are saying is that if we have a trade that requires exiting if it moves 10% against us, using margin on such a trade would be more risky. Of course it would. This is NOT what I am talking about.
    #15     Aug 20, 2002
  6. OK, lets work through your example of a two traders, both 100k cash, both willing to risk 5%, both trading the same stock with the same entry and exit, but with different margin borrowing strategies.

    <b>Aggressive Trader: </b>

    The aggressive trader buys 4000 ABC@100 with $1.25 stop. The trade goes bad, and a 400k position becomes a 395k position before it hits the stop. The aggressive trader pays 300k back to the broker and is left with 95k (the trader risked and lost 5%). Next day, ABC is again @ 100 and the indicators and tape look better. So the trader again risks 5%, buying 3800 ABC@100 with a 1.25 stop. Things go better on the second day, the stock goes up 1.32 before it starts to weaken and the trader decides to take profits. The 3800 shares @ 101.32 yield 385,016, from which the trader returns the 285k (95k x 3) that was borrowed. So, before commissions and margin interest, the aggressive trader is left with 100,016 at the end of trade 2. Not a stellar outcome, but at least the aggressive trader is basically out of the hole.

    <b>Conservative Trader: </b>

    The conservative trader decides the play the identical trade, but buys only 1000 ABC@100 with $1.25 stop. The trade goes bad, and a 100k position becomes a 98,750 position before it hits the stop. Next day, ABC is again @ 100 and the indicators and tape look better. So the trader again tries the same trade buying 987 shares (forgive the odd lots, please) of ABC@100 with a 1.25 stop (with 50 bucks cash left over). Things go better on the second day, the stock goes up 1.32 before it starts to weaken and the trader decides to take profits. The 987 shares @ 101.32 yield 100,002.84 (plus the $50 in cash left over from not being able to buy a 1/2 share) So, before commissions, the conservative trader has 100,052.84 at the end of trade 2.

    <b>Fair Comparison? </b>

    But wait, you say, the comparison is not fair because the conservative trader did NOT risk 5% of their account on this trade. To which I say: that is EXACTLY my point. The aggressive trader risked 5% and still came out behind the conservative trader who only risked 1.25%. As a trader, I want to gain more for my risk, not less. Worse, at a 0.01 per share, the aggressive trader would have paid $156 in commissions (plus interest), the conservative trader only $39.74. So, the aggressive trader risked more to come out with less while playing identical trades on ABC.

    What have I missed????
    #16     Aug 20, 2002
  7. I might be rehashing, but this whole question seems to simplify itself if you focus on actual capital at risk.

    If you have fifty grand and want to risk 2% per trade, you define your exit strategy in such a way that you lose a thousand bucks if you are wrong (give or take) and let the leverage requirement handle itself.

    Excluding commish for the sake of simplicity:

    If you are risking a dollar, that means you can take one thousand shares because $1.00 x 1,000 = 1K risk.

    If you are risking ten cents, that means you can take ten thousand shares because $0.10 times 10,000 = 1K risk.

    In the first case you probably don't use leverage, in the second case you probably do, but in both cases theoretical risk is the same, $1,000 or 2% of 50K, as determined as a function of initial capital at risk.

    So you factor your size based on YOUR money (not the house's), use leverage if you need it, and don't use it if you don't. Focus your energy on determining a viable and desirable percentage of initial capital at risk, and let the margin use take care of itself. If you consistently need more leverage than the house is willing to give you, odds are very high you are trading too big and en route to a blowup.

    The KEY thing to understand is this: the more leverage you use and the tighter the stop you use, the greater your exposure to a freak loss, because theoretical/desired risk has to match up with actual/real world risk.

    For example: the odds of a stock gapping a dollar within seconds are arguably much greater than the odds of a stock gapping ten dollars overnight. This means that if a daytrader routinely calculates his leverage on ten cent stops and a swingtrader calculates his leverage on one dollar stops, they could both have the exact same theoretical risk per trade, but the daytrader carries a much higher real risk of a ten to one oops blowout, because the odds of a two second dollar pop or drop beat the odds of a ten spot overnight any day of the week. The more leverage you use, the more respect you must pay to the minimum threshold of real/absolute risk.

    Correlation is another issue but fairly simple also: the more highly your positions are correlated, the more they will demonstrate an outcome similar to having one fatdaddy trade on (with corresponding fatdaddy risk).
    #17     Aug 21, 2002
  8. You haven't missed anything; we've both really been talking abou the same thing.

    Perhaps I have missed something. I have always thought that, using the same strategy, a trader willing to risk more is going to earn more, but endures the increased probability that he will lose all. I guess you are saying that that is not the case? That, with some strategies, a more conservative approach will yield better results?

    You gave an example of one trade above. I am interested in whether you have done further testing to verify your theory. I ask this because with every system I've tested (and seen tested) the potential reward increases roughly commensurately with the risk of ruin; normally culminating in a point where to risk more doesn't provide a greater enough reward to warrant the greater risk - something Ralph Vince calls Optimal F. In the real world, however, most traders (most intelligent traders), I would imagine, would not risk an amount that would take them over a 25-35% drawdown; meaning that traders don't even approach risking anything near the optimal f amount.
    #18     Aug 21, 2002

  9. I'm not sure if Alpha is saying that or not, but I'll say it regardless.

    Maximizing gains and minimizing losses have a definitive real world link- a principle of reality embedded in all forms of risk taking activity. Figure out that link and you will understand why the above is true.
    #19     Aug 21, 2002
  10. Thank you father darkhorse for pointing me towards the patently obvious.... (i'm not really sure why you even posted this..)

    Don't you agree that in trading (and in life, as you were so kind to point out), the more one is willing to risk the greater the potential rewards? I thought alpha said quite clearly that he has found that some strategies do not follow such a risk:reward profile. That is what I was interested in.
    #20     Aug 21, 2002