19 Sep Leverage in trading

Why do brokers offer leverage?

When look­ing to trade Forex or com­modi­ties like I am, you’ll find many bro­kers offer­ing a lever­aged account. Pro­mo­tions on how you can trade 40.000 dol­lars with only 100 dol­lars in your account. What’s up with that, right?! The way they do that is by offer­ing you this thing called lever­age. In the case of the exam­ple, 400:1. That means 400 to your 1 dol­lar. Sounds great right?! SPOILER ALERT! The answer is: ‘not necessarily’.

DISCLAIMER

Click here for my dis­claimer. It basi­cal­ly says that I am on my path to becom­ing a trad­er and these are just my opin­ions on how to approach learn­ing to trade. Feel free to check it out and com­ment on it. 

Here it goes…

The lit­tle guy

One rea­son I believe these bro­kers offer ‘lever­age’ is because it makes trad­ing acces­si­ble to a larg­er audi­ence. Espe­cial­ly those with­out suf­fi­cient funds to trade big quan­ti­ties of stocks, com­modi­ties, etc. On top of this, bro­kers, make their mon­ey by col­lect­ing some­thing that is called the ‘spread’. The spread is the dif­fer­ence between the ask and bid price. Ask being the low­est ask price (the sell­ers) and the high­est bid price (the buy­ers). So if the ‘ask’ is 50 dol­lars and the ‘bid’ is 49 the dif­fer­ence is 1 dol­lar. This is the amount the bro­ker get’s per unit per lot. The lot sizes change accord­ing to the finan­cial instru­ment that you are trad­ing. For me trad­ing WTI crude oil, one lot is 1000 bar­rels. Mean­ing if I had bought 1 lot in this exam­ple 1000 dol­lars would have gone to the bro­ker. Not too shab­by huh?! Although spreads are usu­al­ly very small of only a few cents. Still, of course, it remains a lucra­tive business. 

Break­ing down the spread

Let’s keep it sim­ple and stick with the 1 dol­lar spread. When I take a long posi­tion (mean­ing that I think prices will go up) and the cur­rent ‘actu­al’ price (not the ask or bid) is 50 dol­lars. I will be down that 1 dol­lar spread per unit per lot. So it’s kin­da like buy­ing it at 51 dol­lars. Mean­ing I am down 1 dol­lar a unit from the get go. Now keep in mind that this is just an exam­ple and the spreads are usu­al­ly just a few cents. If I would have gone short (bet­ting that prices are going down( with the cur­rent price being 50 dol­lars, I basi­cal­ly place my posi­tion at 49 dol­lars. So either way, by default, I start off in a deficit. In this case 1 dol­lar per unit deficit. The bot­tom line for the spread being, and I’m quot­ing Investo­pe­dia here, ‘The bid-ask spread is essen­tial­ly a nego­ti­a­tion in progress’.

Let’s lever­age some stuff

So the bro­ker makes mon­ey off the spread. Obvi­ous­ly the more units we trade, the bet­ter for the bro­ker. So let’s take my account as an exam­ple. I have read about the ‘dan­gers’ of hav­ing an over-lever­aged account so when I saw that the low­est my bro­ker offered was 50:1, I took that. Mean­ing that for every one of my Euros I can trade 50 times that. In my account, keep in mind this is the paper trad­ing account I speak of. Not sure what that is? Click here. My ini­tial account size is 10.000 Euros. Mean­ing I could buy or sell up to 500.000 Euros. Neat, right?! I know I know. I’m get­ting there.

Break it down, baby!

In my exam­ple, I am trad­ing 1 lot of WTI crude oil. That means 1000 bar­rels of that black ‘good’ stuff. Black gold. The sticky icky! Pret­ty sure that last one was no refer­ral to crude oil. Any­way, with my account I have tak­en many posi­tions going long or short. But when a trade went against me (mean­ing I was los­ing on the trade) I sim­ply kept the posi­tion open. In a mat­ter of days price action would turn around and I’d could close the posi­tion on a prof­it. Now, I know what most ‘pros’ on the inter­net say: ‘Cut your loss­es short’. But it was work­ing. Prices went against me. I wait­ed. They turned around and I was rock­ing and rolling to the fake bank. Until, of course, it stopped work­ing. This is where the lever­age comes in. So maybe these ‘pros’ were right?… Nahhh! 🙂

On mar­gin

When you have a lever­aged account. It means that you have a mar­gin account. So your loss­es are cal­cu­lat­ed based on the mar­gin that you have left. This is what my bro­ker says on how my account is build up.

Bal­ance: Your account’s val­ue exclud­ing P/L from open posi­tions — it equals the funds you deposit­ed into your account and your P/L from closed posi­tions. P/L being Prof­it and Loss.

Equi­ty: Your cur­rent account’s val­ue — it equals your bal­ance, plus any P/L from open positions. 

Open P/L: The sum of prof­it and loss from all your open positions.

Free Mar­gin: The sum of funds you have avail­able to use as ini­tial mar­gin for new posi­tions. Cal­cu­lat­ed by sub­tract­ing the mar­gin user by your cur­rent open posi­tions from your equity. 

Used Mar­gin: Indi­cates the sum of mar­gin being used by your cur­rent open posi­tions. Cal­cu­lat­ed by adding the ini­tial mar­gins of all your open positions. 

Main­te­nance Mar­gin: The min­i­mum amount of equi­ty required to main­tain your cur­rent open posi­tions. If your equi­ty lev­el drops below this num­ber, your open posi­tions will be auto­mat­i­cal­ly closed. 

Mar­gin Lev­el: Indi­cates how close your account is to a mar­gin call. Cal­cu­lat­ed as Equity/ Ini­tial Mar­gin and shown in %. When Mar­gin lev­el drops below 100% you will not be able to open new posi­tions. And if it drops to 50% all your open posi­tions will be closed and work­ing orders will be can­celed automatically. 

Avail­able for with­draw­al: Amount of mon­ey you are able to with­draw after clos­ing all your open posi­tions. It equals to your cur­rent equi­ty, minus any non-trad­ing relat­ed incen­tives as stat­ed in our T&Cs for Incen­tives and Loy­al­ty Awards.

Say what now?!

Let’s look at it by using an exam­ple. For my exam­ple I will use one long posi­tion open (long or short doesn’t mat­ter) of 1 lot. This lot I pur­chased at 47 dol­lars. Let’s do the math.

• 1 lot = 1000 bar­rels, 1 bar­rels costs 47 dol­lars, so that makes 47.000 dollars
• my lever­age is 50:1 that would mean that to take the 1 lot posi­tion my account gets charged 47.000 divid­ed by 50 = 940 dol­lars mar­gin used
• let’s say the cur­rent price went down (i’m at a loss) 25 cents per bar­rel at 46.75.
• 0.25 times 1000 bar­rels = 250 dol­lars loss

Fill­ing in the blanks

Bal­ance: 10.000

Equi­ty: 9.750

Open P/L: -250

Free mar­gin: 9.750 (equi­ty) — 940 (used mar­gin) = 8810

Used Mar­gin: 940

Main­te­nance Mar­gin: 940 (used mar­gin) / 2 = 470
Mar­gin Lev­el: 9.750 (equi­ty) / 940 (ini­tial mar­gin) x 100 = 1.037%

Avail­able for with­draw­al: 9750 (equi­ty)

Get­ting to the nit­ty gritty

So what blew up my account?! In this part we’re gonna dive deep­er into the bel­ly of the beast that is ‘lever­age’. But first, let’s get one thing straight. If I had cut my loss­es short I wouldn’t have blown my account. I get that. My aim here is to find out how many posi­tions with how much loss­es I can have before I hit a mar­gin lev­el of 100%. Because that’s when I can’t open new posi­tions any­more. Then how much do I have left until I hit 50%. Because then my open posi­tions get closed out, one by one, start­ing with the biggest loss. This then alle­vi­ates the mar­gin lev­el but you’re most like­ly to stay in the ‘dan­ger­zone’ (50% to 100%). You could either close posi­tions your­self to get you out of it so that you can take new posi­tions. Hope­ful­ly with these you could get a prof­it from whichev­er way it’s going at the moment and build more margin.

The nit­ty gritty

So we have to come up with a way to under­stand the ratio between the amount of posi­tions open and the loss­es that they have incurred up until a cer­tain point. By doing this we can bet­ter guess how many posi­tions we can have open/ How much per­cent­age loss each posi­tion can have. How much per­cent­age that posi­tion will take away from our mar­gin lev­el. Thus, in the end, tell us how much ‘buffer’ or mar­gin we have before we blow up our account. 

First we are going to under­stand how one posi­tion open affects our account. After­wards, we will add posi­tions open and play around a bit with loss­es and wins of those posi­tions. To see how it affects the bot­tom line.

Con­clu­sion

When trad­ing with a 10.000 Euro account. Tak­ing 1 lot (1.000 bar­rels) posi­tions each time. At a lever­age of 50:1. I don’t have much room for error if tak­ing too many posi­tions. After play­ing around a bit I can assume that I can have 5 los­ing posi­tions open with a los­ing mar­gin of 1 to 2 Euros. Or I could trade small­er lots but more of them. This way I can still take posi­tions with­out get­ting into the dan­ger zone too quick. So what have I learned really? 

Les­son 1

Don’t take too many posi­tions because that rais­es the risk of hav­ing trades go against you. 

Les­son 2

Set an amount you are will­ing to lose on each trade. This I will base on the aver­age prof­it I took from the trades that did go my way. To test this I will explore these trades a bit more in a future article. 

Thank you for reading

If you’d like to get my Excel sheet on how to cal­cu­late the mar­gin lev­els of your trades, please drop me an email or sub­scribe. And as always. Please leave a com­ment. Troll me. Tell me how stu­pid I am and show me how it’s done.