10 December 2012

In For a Penny, in For a Pound

Too often novice traders start trading with large volume, made possible by excessive leverage - it’s no surprise that the majority quit the market within six months. It’s important to understand leverage and how to utilise it correctly.

Also available in Japanese

Trading any financial asset can be done in various ways, with a variety of objectives, expectations and outcomes. Whereas some prefer to invest, others speculate. While some look at long-term trends and perspectives, others focus on the immediate short-term – all because of different objectives and expectations. However, all traders hope for the same outcome – profit. Although the approach to trading can differ, the tools used in trading are always the same, but can be applied differently, also depending on the objectives and expectations of a particular trader.

When it comes to speculative trading, one tool stands out above all the rest in terms of its popularity and application, not to mention the controversy it generates. The tool I’m referring to is leverage and its impact on retail trading has been incalculable. Leverage has made it possible for individual people to speculate on the financial markets, even with comparatively small levels of funding. Not so long ago, only specialised firms or extremely wealthy individuals were able to speculate on the movements of currencies, equities and commodities. The practise was highly specialised and the barriers to entry were extremely high. Not only that, IT was not capable of delivering a robust trading solution to the average person. Nowadays, everything has changed - anyone can open a trading account and try their hand at trading as long as they have a few hundred pounds and a PC with an internet connection.

This could only have been possible via leverage. To explain how and why, let’s take a simple example of how leverage works in practise. Suppose I have decided to try FX trading and open a trading account with £500. There are many FX pairs to choose from but all of them have a variance of about 1% or 2% on an average day. Suppose GBP/USD is trading at 1.5000. This means that on average, GBP/USD will move higher or lower by around 250 pips or less. Of course, there are occasional days when currency pairs move wildly and erratically but on the whole, you can expect any currency pair to have a trading range of 300 pips or less on any given day, all other things being equal. Without leverage, my initial deposit of £500 (invested fully) would generate a profit/loss of approximately 5p per pip. So if GBP/USD were to rise from 1.5000 to 1.6000 (a 1,000 pip move), I would generate a profit/loss of £50 depending on whether I was long or short. The problem is that for GBP/USD to move 1,000 pips is very unlikely in a short time frame. Even over the long-term, currencies do not fluctuate all that much. If you look at any currency pair, it is always quoted to four or five decimals. Most of the fluctuation in any currency pair happens on its third, fourth and fifth decimals which means that a change from 1.50 to 1.51 is in fact, a 100 pip move. Even for the conversion rate to change by 1 dollar cent can take a while to occur and is made up of 100 smaller movements.

Given the fact that currencies (and other asset classes) are not actually as volatile as they are portrayed, leverage helps to create profits and losses within fairly stable markets. The way leverage works is by artificially increasing the purchasing power of your initial deposit several hundred times over so that the initial £500 deposit becomes closer to £100,000 (200:1 leverage) when placing a trade. In this scenario, the same £500 invested fully would now generate a profit/loss of £10 per pip rather than 5p. If I had placed a trade at 1.5000 and closed it at 1.6000, I would have made a profit/loss of £10,000 as opposed to £50. Leverage simply magnifies the outcomes of your trades.

Taking this into consideration, it is important to realise that it is never leverage per se that is the undoing of novice traders, but rather its misuse in relation to their deposit. Brokers have realised that in order to attract retail customers in large numbers, trading had to be made accessible and worthwhile. Leverage was the solution, and unfortunately, it has made a bad name for itself due to the tendency to over-leverage under a cloud of greed and misunderstanding. Not just retail traders have had this problem. Leading up to the financial crisis in 2008, many asset managers, investment banks and institutional investors over-leveraged in their investments. Their objectives and expectations were different to retail traders, but the desired outcome was the same – higher profits. Since then, most institutional investors have deleveraged on a mammoth scale but the retail trading community continues to request highly leveraged accounts from their brokers. This is probably because retail traders are more likely to trade with smaller deposits, (yet have the same desire for wealth accumulation) so to have any chance of generating a liveable income from their trading requires higher leverage.

This makes sense to retail investors, who believe leverage is an effective shortcut to riches, but in truth, this mentality partly explains why 80%+ of retail traders lose most, or all, of their deposit within the first 3 months. Leverage magnifies outcomes but most beginners prefer to think about the potential magnified winnings rather than the magnified losses. It’s human nature after all; but a nature that should be consciously mitigated to ensure a disciplined approach to risk taking. Leverage should only be utilised insofar as it doesn’t breach your core risk limits within your trading strategy.

It’s quite ironic that leverage is the last thing a beginner needs, and yet, it’s one of the most attractive aspects for beginners. So much so, that as leverage for retail traders was restricted in both the US and Japan since 2008, active retail clients in those regions have fallen as a result.

Profit shouldn’t be your initial goal as you start trading because you should be focusing on gradually carving out an effective trading strategy that consistently posts more winning trades than losing ones. And over time, profit should just be a by-product of your trading strategy being enacted accurately, never its ultimate goal.

Commissioned by Forex Club
Written by George Tchetvertakov