Manage Your Leverage in Derivatives Trading

Among the general public derivatives trading is generally considered to be a wildly speculative activity. Most people have little trepidation about moving money into stocks or bonds or mutual funds. But ask them if they have

considered trading derivatives and they get this incredulous look on their face and say “Hey, what do you think I am, crazy?”

What is it about derivatives trading that has earned it such a disreputable reputation? The common perception among the general public seems to be that the individual stocks themselves—are wildly volatile and that volatility is what causes most traders to lose money. While there is no question that stocks can be volatile at times, the markets themselves are not nearly as volatile as many people think, and it is not the volatility of the markets that causes the majority of problems. What causes most of the problems is the amount of leverage used when trading derivatives. This fact is not widely recognized though.

Leverage is the double-edged sword that makes a few people very rich and upon which the majority of derivatives traders fall.

Why to trades Over Leverage?

Unfortunately, the blunt answer to the question “why do traders use too much leverage” is “ignorance.” This is not to imply that everyone who trades derivatives is ignorant (although there are those who might debate this). What

it means is that many traders are unaware of the amount of leverage involved. Too many traders get into derivatives trading without realizing or understanding the amount of leverage involved. People who trade stocks for years (putting up Inr1 of cash to buy Inr1 of stock) often mistakenly

assume that they are doing the same thing with derivatives. They simply don’t realize that when they put up Inr1 they may actually be buying or selling ~Inr7 worth of the underlying. Few people are prepared to deal with 7-to-1 leverage but even there it is led by the thought process of gains on going right, instead of the loss if I go wrong. To make matters worse, those who don’t even realize they are using 7-to-1 leverage have almost no hope of surviving.

Another problem is that there are few warnings given regarding how much leverage is too much. Brokerage houses make money based upon the number of trades made so they don’t have a great incentive to tell somebody “you’re using too much leverage; you should trade less.”

Also, although there have been many good books written regarding money management, there remains no standard method for determining the proper amount of leverage to use when trading derivatives.

Ways to Avoid Excess Leverage Creation.

The antidote for using too much leverage is referred to as proper “account sizing.” Account sizing simply refers to a process whereby a trader attempts to arrive at the “right” amount of leverage for him. The goal is to strike a balance. You want to use enough leverage to be able to generate above average returns without using so much leverage that you expose yourself to too much risk. The ultimate goal of sizing an account is to limit any drawdowns in equity to a percentage amount which will not be so large that it causes you to stop trading. In order to do so you must prepare yourself as much as possible both financially and emotionally for the magnitude of drawdown you are likely to experience using your chosen approach to trading.

Happy Trading!!!

Cheers.