The Truth About Leverage, Margin and Risk
What does it all mean?
Some traders can get confused between leverage and risk. By that I mean when someone says ‘you can obtain this financial product on high leverage or low margin’, they assume this means high risk, when in actual fact the risk is always there regardless of the leverage.
This common connection between high risks: high leverage comes from not understanding leverage properly, but even more so not understanding risk.
To sum it up, risk is the risk to your capital, where as leverage is the ability to control more with less.
First let’s explain leverage better.
If you read my post on CFD’s you’ll have a primer on leverage, but so as not to confuse those who don’t care for CFD’s here’s the run down.
I have an account with $40,000 and I want to buy a parcel of 10,000 shares of XYZ Pty Ltd, which at the current time is trading at $4.00. The total value of this parcel of shares is going to be $40,000. If I decide to buy this parcel of shares, what is my total risk? It is $40,000 (100% of my account); simply because if XYZ falls to $0 tomorrow, I am down $40,000.
Let’s then apply some leverage to it. My broker offers me 1:1 leverage on my parcel of XYZ shares, and so my margin requirement is only $20,000. In other words I only need to have $20,000 to control a $40,000 parcel of shares; my broker lends me the other $20,000 (1:1). Now what is my risk? It’s still $40,000 (100% of my account); because once again, if XYZ falls to $0, I still lose $40,000.
Now we’ll use a CFD. For XYZ, my CFD provider offers me high leverage, and says to me that I can purchase this parcel of shares with only a 10% margin requirement (remember I still have $40,000 in my account). Meaning I am only required to put up $4000 of my own money to control $40,000 worth of shares. What is my risk now? It’s still $40,000 (100% of my account); and again, if XYZ falls to $0, I still lose $40,000.
So what’s the difference? In all three cases, my risk is the same yet the margin requirements; therefore leverage used is different for all three.
Risk is this - it is the chance that you may lose money. This is as simple as it gets. The reason the risk is the same in all three cases above has nothing to do with leverage but everything to do with what you are controlling; and in all three cases I am controlling the same sized asset, i.e. a 10,000 parcel of XYZ shares valued at $40,000, and regardless of the margin required and the leverage used, if XYZ falls to zero, I am down $40,000.
Let’s use a stop loss. For those who don’t know what a stop loss is, it is an order placed in the market to get you out of a position should the market go against you. So after buying XYZ at $4.00, I place a stop loss order to sell 10,000 shares of XYZ at $3.80; and thus if XYZ falls to $3.80, I will have my shares sold in the market.
Let’s look at the risk involved in all three examples after placing a stop loss. In these examples we are looking at theoretical risk, that is we get sold at $3.80 and we do not include commissions and interest costs (I say theoretical because there is always the added risk that price can fall sharply not enabling the broker to get you out at your stop loss - in these cases the broker gets you out at the next possible price).
Example one (no leverage). I sell XYZ at $3.80, and I receive $38,000. As my initial investment was $40,000, I lose $2000. What was my risk? It was $2000.
Example two (I am leveraged 1:1 and my margin requirement was $20,000). I sell XYZ at $3.80, and I receive $38,000. I pay back my broker the $20,000 he lent me which leaves me with $18,000; I lose $2000 ($20,000 - 18,000). What was my risk? It was $2000.
Example three (my CFD provider offers me a CFD for 10,000 shares of XYZ with a 10% margin requirement, which requires me to put up $4,000 and the CFD provider lends me the other $36,000). I sell XYZ at $3.80. The proceeds of that sale were $38,000. After paying back the CFD provider his $36,000, I am left with $2000. My initial investment was $4000. So what was my risk? It was $2000.
So you can see that in all three cases, the risk had nothing to do with the leverage used and all to do with managing the actual trade itself (or the asset which in this case was a 10,000 parcel of shares). If I didn’t use a stop loss my risk is the whole asset. With a stop loss, the risk is the difference between the purchase price of the asset (not my margin requirement), less the proceeds of the sale of the asset.
Next time you place a trade, understand that your risk is the difference between your purchase price of the whole asset, less the proceeds of the sale of that asset should it go against you.
In my next installment, I’ll look at how the leverage trap sucks people in and how we are sold on the wrong type of risk, i.e. margin.
Happy Trading
Dean Whittingham
Elite Insiders Group - Trading Systems
Financial Market Fisherman © 2004 - 2007
