What is financial leverage?

Everybody related to financial markets knows what leverage is, and the majority, except long-term stock investors, has used it. However, even long-term investors cannot escape to the effects of leverage in the world of today.

It is very uncommon that someone has not used credit to consume or produce something nowadays.

That is, in fact, one of the major characteristics of our era: the era of leverage: leverage when we get a house with a mortgage (or a mortgage with a house); leverage when we ask for credit for our small store or garage, leverage for almost everything.

Financial leverage benefits?

Using the leverage we try to use external capital to have more current buying power for either consumption or investment. In the world of finance, the word leverage acquires almost a magical meaning.

When we use leverage in the financial markets, we are being given the chance to trade with more money than we originally have.

The broker will provide for that money giving us the possibility to deposit some margin to trade a contract with much bigger nominal value.

For example, we can deposit 1000 $ to trade the Gold futures that are worth (as for today) about 120.000 $.

Day trading and the danger of leverage

Although once upon a time, I was (tried) to be a day trader I could never understand why anyone would be willing to use those leverages offered by the brokers. 400:1 in some forex brokers, 500 $ margin to trade the SP500, 5.000 for DAX.

I never needed so much leverage for my day trading to fail, which was achieved with 50 to 1 sometimes. But incredible, brokers offer 200, 300 and 400 to 1 leverage, and there are people who use it. I wonder how much they last in the market.

For instance, in the SP500 example, there are people who try to day trade it (today a 100.000$ contract) with just 500 $. If we buy a contract, we will be wiped out if the price moved a 0,5% against us (10 points today). It is an exaggerated example, but the truth is that the brokers never run out of bold day traders that try to trade the SP with just a few thousand.

Financial leverage Forex

Even worse is the case of some forex brokers that offer leverage of 400:1, with which a trader can move 400.000 $ with just a 1.000 deposit.

Can you imagine trading 400.000 $? A lot of guys with 1.000 $ who see it think how beautiful it will be when they go to spend the day in the Caribbean on their yacht. With that sort of leverage, you just need a nominal move of 0.25% against you to go bust. That would be about 30 pips of €$ today.

The problem is that doing day trading –the very activity these low margin brokers try to attract – 99,99% of the traders will end up losing money, some of them going bankrupt.

If the rest 0.01% exist, and I do not know where they are, be sure that they will not sell you their system at any price.

Financial leverage for dummies

That is why my recommendation to anyone is to start doing day trading with a 1 to 1 leverage. That means that if someone has 10.000 $ he trades a 10.000 €$ contract.

Making 20 pips here, losing 30 there, till after enough time that person may determine if the system that promised so much, works in reality. In this way, if the system turns out to be a failure, the trader would not have lost too much; about for example 200 or 300 $. So after that if a trader wants to try another strategy he can move on.

On the contrary, if we had leveraged 100 to 1, trading 1.000.000 €$, it would not have taken too long to be completely wiped out.

Apart from day trading and long term investing, there are other ways to do trading, and those ways are related with trend and swing trading. Doing that sort of trading we do not need that much leverage, and depending on anyone´s case, leverages from 2 to 1 to 10 to 1 should be acceptable. With 10 to 1 the chance of losing is much bigger, but so is the chance of winning more.

In short, the bottom line is not to do day trading, or if we do, do it as moderately and timidly as possible. And above all, forget about big leverage.

 

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