Leverage and the Dangers of Overgearing

Q. Why should you disregard providers flaunting low deposit requirements?


A: Leverage is not what your spread betting provider allows you to use; it is what you decide to use and personally I haven't seen one spread betting or CFD trading account wiped out that wasn't geared too high. Most of the material you read about leverage is about the maximum leverage that brokers will allow and very little is written on the careful application of leverage in the trading sense. In other words, spread betting providers inform you about how much gearing they will allow, should you wish to, and not how much you should leverage, if you're sensible and know what you're doing.

Margin is the amount of funds that you need to deposit with a spread betting or CFD provider when borrowing from the provider to buy into an asset. Now, before your provider will 'lend' you money you have to put down a margin payment, which you will use to 'lever'. Your provider being a prudent dealer has calculated the risk beforehand and is prompt to tell you what the maximum is he will allow you to borrow from him. In foreign exchange trading this is typically 100:1, (but can also be 200:1, 400;1) while in indices this is typically 5% and stocks usually start at 10%. Of course the other side of the deal is how much of this accessible borrowing you are ready to use in your speculative trading. For instance, if you create an account with a spread betting provider, deposit £10,000 and open a stock position for a value of £10,000, you have not made use of any available borrowing.

In the above example the limit is leverage of 2:1 or seen from another viewpoint margin of 50%. You must have at least half the value of your total transaction available in margin (in other words collateral in case you aren't as hot a trader as you thought).

Q. The big plus with spreadbetting is the leverage - but it can work for or against you. So the big plus can be a minus?

A: From what I can see the biggest problem with this method of investing is people's lack of understanding. When the example of investing in BOI states that you can buy €10,000 of the stock with a €2,000 stake - people get a rush of blood and put on as much as they have (say €10,000 - which is the same as buying €50,000). If the stock drops by 10% they loose 5,000! Suddenly it's a crap system because you invested 10k and a 10% drop in the stock results in a loss of half your money!

In reality you should use it as a more efficient use of your 10k, and use it as such:

  1. 2k as your stake.
  2. 2k in your account to cover big potential losses.
  3. 6k on deposit at 2% = €120 per annum.
  4. The €120 per annum would more than cover your expenses and you are being conservative with the above example. You could have some of the 6k in another stock or two.

Whereas if you go the stockbroker method - the costs are way higher (transaction charges/government charges/possible CGT on profits) and your 10k is gone until you sell up! With spread betting you have a lot to play with!

Here's what Matt (a spread betting enthusiast still in his early day who had switched from shares dealing) had to say on the leverage -:

'As someone who has had the 'leverage' button available to use for 7 months now, i resisted for ages before inching my way into it very, very slowly. Takes even more emotional discipline I would suggest than just buying the shares. I'm sure it is very easy to get carried away on leverage when things are going well and the gains seem to be going up at a much quicker rate than previously experienced with just buying shares - Familiarity breeds contempt!

When things start to turn against you though (we all know that falls in prices tend to happen quicker than gains, since fear is a more powerful emotion than greed in the market) then it can quickly become obvious, or dreaded, that you may not have left enough cash to cover the falls. Just at the time when the more experienced investor/trader is getting ready to buy on the dip, the over leveraged speculators often cause an exaggerated fall on the dip by having to close bets before a margin call threatens a wipe-out or an unacceptable loss.

You tend to see it in chart patterns as a drop back for two or three days then becomes amplified for two or three more days as forced leverage sells take the price below what the fundamentals suggest is sensible. One man's loss is another's opportunity and that situation demonstrates the sense of always ensuring you have cash on hand to benefit from such occasions.

I freely admit to having lost some money as I have eased my way into it but, have persevered whilst keeping bet sizes pathetically small and am ahead as I type by probably about enough for a very good holiday, after 3 months from my first bet. I view some losses as 'a cost of doing business' really and no amount of reading or theory can substitute the experience of putting your own money at risk this way.

This way I can learn how it 'feels' and how it works on up and down days without risking a disaster. It takes more monitoring than just shares and you need to learn about moving stops in response to market conditions and as prices move further from your entry point on each bet. Simple stuff but how it challenges your emotional control is the key to it I believe.

I look at my position each day and pretend there are extra zeros on the figures and ask if I would still be sleeping soundly at night. Currently the answer is 'No', so I will continue with it for very small amounts right now & take the learning from it, in expectation that one day it may become the norm.'

I used to measure losses and gains in the markets in terms of white goods. 'Damn, I just blew a fridge.' 'Whoopee, I just made a flat screen.' It is a good technique for keeping you in touch with what's really going on on that spreadsheet. In these volatile times, it has been forced on me to think now of the sharemarket in terms of cars. One of my colleagues lost a Club Sport R8 HSV Holden Commodore on Tuesday. One of my clients lost a Jaguar XK Series. 'A new one?' I asked. 'Fully optioned,' he replied.

Q. If I open a trading account with £1000 and trade 1p/point, and then move up to 50p/point (which I can through Finspreads spread bet account), won't that go some way to prolong my 'longevity' even if I hit a to-be-expected, losing streak initially?

A: Here's a maths test. Which is greater:

0.25% on £5,000 or 1.5% on £1,000

Let me explain it with an analogy:

Imagine you and your friend walk into Curry's and you both see a shiny new HD 42" plasma TV that you both want to buy. You ask the salesman how much it costs and he types a few keystrokes on his computer and says to you, "For you it will be £500" then turns to your friend and says, "For you it will be "£100". You ask him why he is charging you more for the TV and he replies, "I am not. You are both paying exactly the same amount, 20% of what you have in your bank account". This wouldn't be fair would it? In other words, you expect to get the same quantity of goods and services for your money as anyone else, £500 is £500 irrespective of the proportion of wealth it represents.

Let me explain it with a Hypothetical:

Now, take 2 people (A&B) of equal aptitude who wish to start trading. They are both told that they should only risk 1% of their capital when they begin, i.e./ (Start small). So person A has saved up £5000 to put into his trading account whereas person B, who has saved for longer, has £50,000 to put into his trading account. They are both equally inexperienced. Would it be fair that Trader A only risks a max of £50/trade when Trader B risks £500/trade simply because he has more available to lose?

Now let me explain it with a real world example based on myself, no actors were used and no animals were harmed in this story.

Recently I saw a good opportunity to go long on a particular stock. I decided to do via my spread betting account. The stock was worth around £4.50 and I decide to bet £2/point. This gave me the equivalent of 200 shares and I had to put down a deposit factor of 10% of this value - 10% x (200 x £4.50) = £90. Now, I can easily afford £90 and I can easily afford to lose £90...but I don't have £9000 in my account, nowhere near that amount!! No, to me, £90 is £90 and as long as I could afford it, I took the trade. It was a successful trade that returned nearly 100% of my initial risk of £90.

Another example: Last year I saw a good opportunity to go long on the FTSE. I did it with a CFD. This was a £2/point CFD that required a £400 deposit. I deposited £800 into the account even though I would cut my losses at a specific STOP level, which varied, but wouldn't exceed my initial deposit. Again, this was a successful trade and I made 160% of my initial risk. If I followed the 1% rule on this trade it means I would have needed...£40,000 in my account!! Ridiculous!!

So what am I saying? The idea isn't to have so much money in your account that it allows you to trade with stops so wide they won't get hit as often because that is financial suicide! The idea is to improve your proficiency so that your trades show a profit almost from the time that you enter them. That is the one and only goal! Trades that get stopped by the market which then rebounds occur regularly. I can assure you, having the mindset that wider stops will prevent this from happening is financially disastrous.

I think Jesse Livermore summed it up perfectly with these two rules:

The highest profits are made in trades that show a profit right from the start.

No trading rules will deliver a profit 100 percent of the time.

I wanted to add one last thing that a very clever Engineer once said to me:

'An Engineer can do with 20p what any idiot can do with £1'

I suppose you can replace the word 'Engineer' with 'Trader' but I don't think an idiot would last very long in the markets.

Q. I notice that you recommend Capital Spreads, but how do you cope with their charts being delayed by approx 20 mins...

A lot can happen in that time relative to entry exit stops...etc.

A: The charts are in real time - it's only on the demo account where they are delayed.

 ...Continues here - Spread Betting Currencies and the Carry Trade

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