Leverage's "Double-Edged Sword" Need Not Cut Deep

In some fields of business, such as real estate, you'll frequently hear that the way to make money is by "using other people's money". This is true in the case of every real estate transaction that involves a mortgage; when you use a mortgage to buy a house, you are using other people's money, in this case, the bank's. The concept of using other people's money to enter a transaction can also be applied to the financial markets through a tool known as leverage. In this article, we'll explore the benefits of using borrowed capital for trading and will examine the common misconceptions about this tool's excessive risk.

Leverage in Other Markets

Borrowing money from a bank is the most common method that allows the average person to buy a bigger house than he or she could otherwise expect for the amount of money readily available. When this concept is applied to commercial properties, it provides a greater return on equity than if the buyer had paid for the entire property using only his or her own funds.

For example, suppose that you own a leased property that you bought for $1 million and the property returns a net 15% each year; your return on investment is 15% per year. However, suppose that instead of paying $1 million in cash, you mortgage the property and borrow $800,000, and therefore only invest $200,000 of your own money. After paying the interest on the loan, you may only achieve an 8% return, rather than 15%. However, 8%, or $80,000, divided by your equity investment of $200,000 is actually equivalent to a 40% return on your investment. In real estate, this type of leverage is considered perfectly acceptable and is actually encouraged.

Risk From a Different Perspective

Now when it comes to the markets, especially the forex markets, the pundits tend to look at leverage as a dirty word. Many go as far as to suggest that it's a strategy that we should be afraid of, and resisted at all costs. They tell us that leveraging in the markets is a double-edged sword that will cut both ways. If we make a profit on leveraged investments, the returns can be huge; if we make losses, those losses can devastate an account. Of course, there is truth to this statement, but the double-edged sword analogy can give an incomplete account of how forex actually works.

If you understand how leverage works and learn to handle it correctly, you can use its power to build wealth. Returning to the sword analogy, the way to do this is to use the blade to cut out losses quickly, leaving the profits room to grow.

Similarly, some people liken trading with leverage to a journey in a car. You could walk to your destination, but driving is a much more efficient solution, especially if the destination is far away. Driving a car is probably much riskier than walking, and statistically more people die in road accidents. But how many people listen to those statistics and never drive in a car? Investors' fear of leverage is often similarly absurd.

Leverage In the Forex Market

In the foreign exchange markets, leverage is commonly as high as 100:1. This means that for every $1,000 in your account, you can trade up to $100,000 in value. Many traders believe that the reason that forex market makers are prepared to offer such high leverage is because leverage is a function of risk. They know that if the account is properly managed, the risk will also be very manageable. Otherwise they would not offer the leverage, simple as that. Also, because the spot cash forex markets are so large and liquid, the ability to enter and exit a trade at the desired level is much easier than in other less liquid markets.

Let us look at an example of a leveraged position in the forex market and how such a position should be managed. Assume, for this example, that you are interested in trading the U.S. dollar against the Canadian dollar (USD/CAD). Let us also suppose that you have $10,000 of trading capital in your account. One of the first rules in trading your account is to define a risk profile. For example, you may decide to never risk more than 2% of your trading capital in any one trade. This means that you will not be prepared to lose more than $200 in any trade as long as your available capital remains at $10,000. As you can imagine, the 2% rule means that you have a good chance of staying in the game. The odds are stacked against a string of losses, but, by sticking to the 2% rule, a leveraged account can still be reasonably safe.

Factors To Consider

There is more to managing leverage than just setting up a 2% rule - you also have to take the personality of the market into account.

For example, suppose the USD/CAD had a daily range of 70 pips. If each pip is worth approximately $10, then you can only risk 20 pips in order to stick to the 2% rule. (2% of $10,000 = $200 and if 1 pip = $10 then $200 = 20 pips.) Therefore, when you enter into a trade, it is important to place a stop loss no farther away than 20 pips. If the stop of 20 pips is in such a place that the normal back and forth movement of the market is likely to hit the stop, you will be stopped out every time, and will incur a string of losses. As such, it is crucial that your stop be placed in a position that it is unlikely to be hit. If you are trading on a daily chart and that position is farther away than 20 pips, you might have to trade in a shorter time frame where the natural stop is not farther than 20 pips.

So, once you have determined the maximum amount of loss you can sustain, which is a percentage of your trading capital, (the 2% rule), and you understand the best place to position a stop loss so that the 2% rule is automatically enforced, but is unlikely to be hit, then you can use leverage to build profits quickly and efficiently. Whenever you think of leverage, you must think of risk management tools such as the stop order as the safety mechanism that controls its power.

by Selwyn Gishen