Leverage: A Traders Friend or Foe?
When you mention leverage to a trader, one of two reactions is possible. The first set of traders will smile broadly and recall winning trades whose profits were multiplied using leverage. The second set of traders will purse their lips, and remember the time they received a margin call, blaming leverage for quickly draining their accounts. Leverage is, perhaps, one of the most misunderstood elements of trading.
Discussing the proper use of leverage causes some traders to react very positively, claiming that no one can successfully trade with them. Or they react very negatively, claiming that no responsible trader would ever use them. As you will see, both extreme beliefs are erroneous and destructive to a successful trading career.
The Positive Side of Leverage
Lets start with the positive side of leverage. Most successful traders will readily admit that one of the key benefits of trading is leverage. In brief, leverage is the ability to control a large amount of any financial instrument like a currency or stock using only a small amount of capital. Heres an example using equities. A trader can use cash or margin to purchase a stock. In a cash account, the trader simply pays for stocks from the cash in his or her account. A margin account is different. Using a margin account, a stock trader using 2:1 leverage can purchase twice as many stocks as the trader using the same amount in cash money. Here is when it gets really interesting. A stock trader can leverage at a rate of 2:1. But a currency trader can leverage at a rate of 100:1 in a standard account. In a mini account, a currency trader can trade at a rate of 200:1! Yes, that amount of leverage is mind-boggling. Its enough to make many stock traders drop their S & P 500 list and start trading currencies. But wait.
Well see that this is not the whole story so hold on to your equity index lists.
Commodities traders cant access as much leverage as currency traders, though they can leverage considerably more than stock and option traders. To use leverage, a trader must have a margin account, which requires placing a performance bond (or a good faith deposit) with the brokerage firm. The list below summarizes the amount of leverage that can be used for each type of trading instrument.
- Equities: Leverage is 2:1.
- Options: Leverage is 10:1.
- Futures: Leverage is 20:1.
- Currencies (Standard account): Leverage is 100:1
- Currencies (Mini account): Leverage is 200:1.
With all the leverage that a currency trader can use, and the simple matter of opening a margin account, why would any one hesitate to use the margin for trading stocks, options, commodities, and particularly currencies? Why wouldnt they use all the leverage available to them to maximize their trading profits?
The Negative Side of Leverage
There is a negative side to the leverage issue. There are losses. Leverage treats price movement equally: maximizing profits and maximizing losses. Losses are multiplied just like profits. Remember the margin call reaction in the opening paragraph? A margin call is made when a trader needs to pay additional funds to the brokerage firm to cover his or her losses, which can quickly accumulate from trading on the margin. Many people believe that an account cannot fall below zero. That is true only for a cash account. For a margin account, the balance can fall far below zero. This is a very real possibility. It does happen. In fact, many traders have received margin calls or even had their positions sold to cover their losses. In short, a trader using a cash account can only lose his shirt. But a trader using margin can lose more than his shirt!
Friend and Foe
That depends on how it is used. If margin is used irresponsibly, then profits and losses will accumulate very quickly. If margin is used prudently, profits can be maximized and losses can be kept to a minimum. There is a safe way to use the margin so following the prudent margin rules can make leverage a friend to every trader.