The Dangers of Leverage

Discussion in 'Prop Firms' started by EvOTraderV2, Feb 10, 2012.

  1. Here's a chart of how much your account balance changes if prices moves depending on your leverage. I put this together for someone I am training. I'm trying to point out the dangers of leverage. More leverage means more risk, not more profits. It provides more opportunity for profits, but increases the odds you will lose your money.

    Note what a 1% change at 30:1, you lose 1/3 of your account. Scary figures.


    Leverage % Change in stock % Change in account
    100:1 1% 100%
    50:1 1% 50%
    33:1 1% 33%
    20:1 1% 20%
    10:1 1% 10%
    6.67:1 1% 6.67%
    4:1 1% 4%
    1:1 1% 1%
     
  2. OGTrader

    OGTrader

    Yeah, these figures make sense but, part of being a trader means understanding risk. I would hope traders don't dump all their cash into a play and hope for the best. Many odds should add up to making a trade.

    I personally don't use a very large account (50k) and I'm very happy with my returns and how minimal I can turn my loses. Anything over 100k in my opinion is too bulky but, if a trader can handle it, more power to them!
     
  3. Completely wrong. A higher leverage does not automatically mean "more risk". What it means is to more efficiently use the capital.

    It always depends on how much money the strategy requires.
     
  4. OGTrader

    OGTrader

    Very well put +1
     
  5. Is there an example where higher leverage is less risky than less leverage for the same portfolio?
     
  6. Let me interject something. I think you guys are comparing two different things here. "Portfolio" leverage implies holding stocks for a longer period in most cases. So, if you have $100k, and hold $500k in positions, then yes, the SPY position or whatever, could cost you a lot of money.

    Now for traders, the "use of capital" can have a completely different meaning. As mentioned before, we like to trade the opening gaps. My top people had their best month in January, mostly from the opening and of course pairs.

    By placing 30 buys and 30 short sells, for example, say 1,000 shares each. 2,000 shares x 30=60,000 shares. Average price, say $40. so, you have entered $2.4Million worth of orders, hoping to make $500-1,000 or so. Now, we know that you can't be filled on both long and short, so that cuts the "risk" by half, down to $1.2million. We generally run about a 10% fill rate, so that brings the amount down to about $120,000. Certainly reasonable.

    And, with most hedging strategies, the use of capital does not necessarily equate to higher risk overall. Yes, "Stuff" can happen, but by spreading out your overnight pair portfolio, you can flatten that risk curve as well.

    I'm sure my friend Mr. Maverick will have some objection to my analysis, but I know how he feels about the Chicago firms and their adversion to "naked" long or short positions as well.

    FWIW,

    Don
     
  7. Leverage is not equal to margin, as Don pointed out. I also want to point out that Don is speaking in regards to hedged strategies, where the spread is what you can lose by keeping both long & short positions.

    Be mindful that getting into trades long or short intraday without hedging and using the chart above can demonstrate what a 1% move will do to your account. at 33:1, 1/3 of your capital can be gone.

    I've seen it happen to MANY traders over the years make the mistake that more leverage will equate to more profits. If you are overall net positive in your PnL, you would be correct.

    If, however, you are net down overall, you are maximizing your loses by using more leverage. Using calculated leverage and using it responsibly is something every trader needs to learn.

    the 95% lose statistic is right and often it's because the trader goes "All in" using large leverage. It's a surefire way to lose your account ;-)
     
  8. Fair enough. But you are really trading $120,000. If you were trading 1.2MM then your risk would certainly increase: especially if you had only 120,000 in equity now levered 10x vs 0x.

    Or if you had a delta hedged option, if you had 2 then you would have more risk, if your account equity was not 2x.

    And the OP's analysis isn't complete. The compounding kills you too. In his 20:1 scenario. a 1% move costs him 20%, a 1% favorable move after that makes him down 4% net.
     
  9. Let's say you bought USD/JPY and it goes up by 1% from 120.00 to 121.20. If you trade one standard $100K lot, here is how leverage would affect your return:
    Leverage Margin Required % Change in Account
    100:1 $1,000 +100%
    50:1 $2,000 +50%
    33:1 $3,000 +33%
    20:1 $5,000 +20%
    10:1 $10,000 +10%
    5:1 $20,000 +5%
    3:1 $33,000 +3%
    1:1 $100,000 +1%

    Let's say you bought USD/JPY and it goes down by 1% from 120.00 to 118.80. If you trade one standard $100K lot, here is how leverage would affect your return (or loss):

    Leverage Margin Required % Change in Account
    100:1 $1,000 -100%
    50:1 $2,000 -50%
    33:1 $3,000 -33%
    20:1 $5,000 -20%
    10:1 $10,000 -10%
    5:1 $20,000 -5%
    3:1 $33,000 -3%
    1:1 $100,000 -1%

    The more leverage you use, the less "breathing room" you have for the market to move before a margin call.
     
  10. For one step. When you start to get to 2 steps or 3 steps it's easy to see the negative effect that leverage plays. You will slowly drift your account to zero. This is why those levered ETF's are a disaster.
     
    #10     Feb 10, 2012