Martin Wolf, in his excellent column for Financial Times, points out that a 15.4% annual return for a hedge fund would be "handsome." How many of you that read this blog would be willing to show up at a trading expo and brag that you had achieved a total return of 15.4% over the last 12 months of your trading?
He then goes on to talk about how a mediocre hedge fund manager can produce such handsome returns in seemingly easy fashion by allowing himself to go deep into debt (leverage) at risk of blowing up the fund. What is this excessive risk? Here's a quote:
Hardly a week goes by without the implosion of a hedge fund. Last week it was Carlyle Capital, with an astonishing $31 of debt for each dollar of equity. But we should not be surprised.
I am not making that up. That's what smart financial people believe to be "astonishing" leverage. 31 to 1. Most currency traders trade with 100:1 leverage.
What makes leverage such a big deal? Why does leverage, in and of itself, present such a problem?
First of all, the availability of high leverage encourages a trader to amass a large trading position, even with a small account. Let's take a trader with a $5,000 account. Let's say that his dealer allows 100:1 leverage. This trader puts up $2,000, and in turn is able to command a $200,000 position in the market. Each pip / point that the position moves for him, he makes $20. If the market moves in his favor 50 points, he's made $1,000. That's nearly enough to make a car payment, buy some groceries, perhaps even make a rent payment (at least in West Virginia, where I live -- it could even pay a mortgage).
This all sounds good so far, right? The trader makes a good trading decision, makes a 10% return in one trade, pays some bills, and moves on. Leverage seems to be the friend of the trader. Where else could this person put $5,000 to work so efficiently, so quickly, with such seemingly easy profits? The stock market? Heck no!
In the stock market, this trader would put $2,000 up -- and then be able to command, at most, a position of $4,000 worth of stock (those are the rules -- you can only trade with 2:1 leverage at most in the stock market). If the market moves 50 points, which is unreal in the stock market (can you imagine GE moving 50 dollars in one day?), the trader is likely to make about $50. No wonder so many people are flying out of stock trading and racing into margin currency trading.
This all sounds good so far. The currency market simply allows for a maximization of profits with a small account.
The problems start when this trader begins to have some losses. Instead of making 50 points and $1,000, he loses 50 points and draws his account down to $4,000. If he has a 70/30 trading system that wins on average 7 times for every 3 losses -- he could experience 1, 2, 3, 4 -- or more -- losses in a row and suddenly be looking at a severe reduction in his trading account. Maybe this trader is disciplined in every other way. Maybe the system is tested. Maybe he's a stable person.
But if he loses just 6 times in a row, he's going to have lost $6,000. Um...that's more than he has in the account. He can't even go more than 5 losses in a row.
The problem isn't that leverage exists or that it is available. It's that most of us, when we start trading, don't realize how fast we can run through our entire accounts. We risk more because we can make more and we end up losing more.
