Leverage. It’s the swing factor that can make your fortune, or wipe you out.
Some traders can use leverage with great effect. It lets them control a large parcel of shares for only a fraction of the underlying value.
But for others it can be a disaster. Big positions can quickly become big losses. Traders who don’t fully grasp this can see their capital vanish in no time.
Last week I put you to the test. I told you the price of gold would rise 90% in three years. I then gave you two trading options. Your challenge was to make as much money as possible.
Option 1 was to do nothing fancy. You could simply buy gold with your available capital. A certain profit was waiting for you to collect.
The second option was more exotic. It involved using CFDs to magnify your returns. This would give you leverage 100 to 1.
How did you go?
I suspect more than a few people loaded up on the CFDs. And I can understand why. It’s like knowing the next colour on the roulette wheel will be black. You can never bet enough.
Or so many people think…
You see, trading is different to games of chance. You not only need to get the final outcome right, you also have to be able to stay in the trade. Leverage makes that task harder.
Here’s the chart you saw last week.
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Yes, gold rises from $1,000 to $1,900. But were you able to hold on during the sell-off?
Here’s the thing. Markets rarely move in a straight line. They can take many paths to get to their destinations. This can have a big impact on your final result.
Take our example for instance. Gold fell by $319 before soaring. That works out to an interim loss of $31,900 for each CFD. Many people simply couldn’t hang on.
Leverage can boost your returns. But it can also be lethal. Leverage can lead to an early exit — or worse still, a complete wipeout. You need to treat it with respect.
Keeping it real
The gold trade is of course hypothetical. Now I’m going to share a real example with you. It involves a short signal Quant Trader gave last December.
Have a look at this next chart.
Click to enlarge
This is the trade chart for one of Quant Trader’s short signals — a company called Bradken [ASX:BKN]. The entry level was at $3.35 on 2 December 2014. An exit stop was set at $4.92.
Quant Trader sells into weakness. You see, the odds favour a trend continuing. But there’s no guarantee of this. Markets can reverse course without warning.
BKN received a takeover proposal just four days after Quant Trader’s short signal. This sent the shares soaring to $4.80 — just 12 cents from the exit stop.
Few things are set in stone when it comes to the markets. The bid fell over a few weeks later. BKN’s share price has been in a tailspin ever since.
Here’s what the chart looks like now…
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BKN is down 85%. This makes it one of Quant Trader’s best performing short trades.
But look at its path. BKN hasn’t gone from $3.35 to $0.50 in a straight line. The shares went via $4.80. The key to making a profit was being able to hold on.
Have a read of this next email. It’s an excerpt from a message I received back in February.
‘I was forced to sell half the BKN shares due to a margin call at $4.45. The remainder I held until two days before the failure of the bid and sold at $4.14. I didn’t want to hold on until the stock hit the stop loss and loose even more money.
‘I know I over reacted with a $4,000 position and it cost me dearly, I guess my emotions ran a little wild playing catch up for those good oil positions I missed!’
I remember reading this email for the first time. I was so disappointed for Julian. He’d emailed me after the initial price surge and I was hoping he’d held on.
This is the danger with leverage. Julian lost his grip on one the year’s most profitable short trades. His forced exit took him out at precisely the wrong time.
Sure, everyone wants to multiply their profits. But the flipside is that leverage also amplifies the losses. This is something many traders overlook. It can be a costly mistake.
I’ve seen plenty of traders come and go over the years. And I can tell you this. High leverage strategies often end in disaster. The risk of ruin is so much higher.
It’s possible to make a lot of money with leverage. But it only takes a few mistakes to bring it undone. Your portfolio could take years to recover.
Professional traders typically only risk a small percentage of capital per trade. It’s all about ensuring they stay in the game. Carefully managing leverage is a critical part of this.
I’m pleased to say this story has a happy ending. I heard from Julian a few weeks ago. He reports that he’s showing a profit for the year. This is terrific result.
All traders make mistakes — I know I’ve made plenty over the years. The important thing is that we learn from these and get better.
Sure, use some leverage if it’s right for you. Just be sure you keep it under control. Don’t let too much leverage turn the year’s best trade into a disaster.
Until next week,
Editor, Quant Trader
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It won’t come as a surprise to know the lead story this week was tumbling commodity prices. On Monday Jason Stevenson asked the question, ‘will resource prices ever recover?’ A lot are saying no. In fact the general theme is an ongoing bear market for commodities. Jason says they’re wrong. He’s been bearish on commodities for two years now. But now he thinks events in 2016 could turn him into to a commodities bull.
Thursday’s Money Morning was all about oil too…actually no it wasn’t! Callum Newman highlighted the real big energy story of the week. And it wasn’t oil. Callum explained that the first cargo of US gas from the ‘lower 48’ States is set to roll as the US exports gas. This combined with weak energy prices might actually be a good thing. It could keep inflation down, interest rates low and even lead to a new boom in markets.