Liquid Trader commented on my last post and his observation motivated me to write something about leverage for beginners: Should they use it, and, if they should, how it is to be used?
What is leverage? According to Wikipedia: “In finance, gearing is borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified and/or enhanced. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity. Deleveraging is the action of reducing borrowings.”
As an example: The most common way of leverage is buying investment property. Simply, you borrow money from the bank to buy house; you pay your bond and all capital appreciation is for your benefit.
Leverage is widely used in trading and stock investing: Futures, options, warrants (widely used options in South Africa), contracts for difference, and the mother of all - FOREX. Many beginners are attracted to possibility of putting small deposit and having big exposure. In Forex trading normal leverage is 1:100, but you could find one with 1:200, 1:500, and even 1:1000. Futures are around 1:10 and options, at least in South Africa, around 1:5.
Leverage can be very dangerous if one does not know how to use it. I believe it is extremely painful to watch account going dry very fast, as the higher the leverage, the faster money disappears in front of your eyes.
On the other hand, leverage is very powerful tool to maximize your profits, and such tool comes with price tag.
I would recommend all readers of this blog to first find out if future trading is for them. If yes, then entries and exits should be paper-traded for at least 3-6 months, in order to build confidence in system that is traded. Only after that, one should start trading it and, at the beginning, it should be done with smallest possible leverage. Maximum that I would recommend, for first year or two, is leverage of 1:3. As time passes-by one could increase leverage, but be cautioned and even afraid of going mad with it. Use leverage responsibly and you will reap the benefits.
This is marathon run. It is not sprint. It is important to be here in 5 or 10 years from now. If you manage, you will place yourself in category of very few.