Risk Management of Leverage Trading

I am sure you have heard this one before. Leverage is a double edged sword. It can make you great but it can also lead to your downfall. Hence risk management is very important when trading with leverage. What are the best leverage practices?

For futures trading in S&P futures at the exchange for example, you can use margin as low as 5%, so that means you can use $5 to buy $100 worth of futures. In FX, it’s even higher, you can leverage up to 1 to 100 or even 1 to 500. However that does not mean you should use that amount of leverage. In the book by Ben Robson titled “Currency Kings”, he has shown that retail traders who used less leverage tend to perform better than those using more leverage.

A more sound policy would be looking at the models of banks and prominent brokerages like Interactive Brokers. Last I checked, Interactive Brokers allows up to 2 times margin. In a property purchase, depending on which country you are from, the down payment will range from 10% to 25%, with the remaining being a secured loan from the bank. For the second property purchase, the bank may only allow a lesser amount to be borrowed (to prevent you from being too over leveraged) so you may just end up borrowing 50% for the second property. So that puts it around the same as Interactive Brokers, you can only buy $100 of the asset if you have $50. This is a more conservative approach to leverage trading for indices, and the index would need to drop 50% before you have a margin call, and that usually happens only during crisis which is not that often.

If you still do not feel comfortable about this amount of leverage, another way to do this is to have enough money to make the whole purchase but use my method instead. What do I mean? Let’s imagine you have $100 to invest. Instead of using $100 to buy the whole index, you use $50 to buy the $100 index and then use the remaining $50 in a safe investment, like buying a bond index fund. Hence even if you get a margin call, you can sell your bond investment to top up the balance. Moreover at that time of the stock market selloff, your bond fund would have performed well, enabling you to sell higher than your purchase price. This is what we called a “Synthetic Equity” strategy as written by Michael Schlachter in his book titled, “Invest like an Institution”. In fact this is what pension plan managers do in their job, they buy stock index futures, putting up the required margin of 5% to 10% and invest the rest of the money in low risk T-bills or short term fixed income securities. Schlachter has shown that these portfolios deliver fairly consistent small positive returns above the benchmark (consistently above the 50% percentile).

Some people have asked me about my last post, are CFDs or spread betting the same as buying stock index futures? The answer is no. The retail broker makes a lot of profits through the interest you hold overnight with them. Let’s take for example you have $100, and you buy $100 worth of S&P futures. Due to margin requirements, the broker takes $5 worth of your capital and you have $95 left to do something else. Woohoo, happy days right? Not really, in this case, they will charge a daily rolling interest on the $95 they supposedly lent to you (remember you used $5 to buy a $100 product, so technically they are lending you $95). However, you may say, hey I do not need that $95, I have $100 in that account. Sorry, that’s how they make their money off you. Hence please do not use CFDs for long term investing; the interest will impact your returns massively. Stock Index futures are a better way for long term investing. The interest cost and dividend benefit is reflected in the futures price and the only cost you pay is the bid offer when you first buy the future and when you roll over them in a few months’ time. The bid offer will of course be a touch wider for retail traders, but it’s at least better than paying interest on your CFD position. So far I know that CMC markets and Thinkorswim platforms allow you to purchase futures and not the CFDs. I am happy to compile more brokers if you know that they do provide futures trading.

Woohoo, you are set for stock investing, but the question is how much should you put in the stock market now? The other experts say that when you are young, you should take more risk, so let’s say if you are in your 20s, you should put in 80% in equities, but do you get a voice in your head that stock markets are too high at the moment, you should pare back that percentage? How about if you are in your 60s and your financial consultant tells you should put in a maximum of 20% in equities but this was 2009 and stocks had sold off 60% from the highs and you wonder whether you should listen to your financial consultant on this percentage. I will talk about this in my next post.