It’s the swing factor that could make your fortune or wipe you out.
Some traders 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 ends in disaster. Leveraged 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 gave you two trading options to play bitcoin’s 1,900% rise. Your challenge was to make as much money as possible.
The first option was to do nothing fancy. You could simply buy bitcoin with your available capital. A certain profit was waiting for you to collect.
Option two was more exotic. It involved using CFDs (contracts for difference) to magnify your returns. This would give you leverage of 25 to one.
How did you go?
Why leverage is harder than it looks
The leverage of CFDs is irresistible to many people. And I can understand why. Imagine knowing the next colour on the roulette wheel was black. You can never bet enough.
But trading is different to games of chance. You not only need to get the outcome right, you also have to stay in the trade. Leverage makes that task harder.
Here’s the chart you saw last week:
[Click to open new window]
Yes, bitcoin rises from $1,000 to $20,000.
But were you able to hold on during the selloff?
Now here’s the thing: Markets rarely move in a straight line. They can take many paths to get to their destinations. And this could have a big impact on your result.
Take the bitcoin example for instance. Prices fell by $829 before soaring. That works out to be a running loss of $20,725 for each CFD. Many people simply couldn’t hang on.
Sure, leverage could boost your returns. But it can also be lethal.
You need to treat it with respect.
This is not a drill
The bitcoin trade is of course hypothetical.
I’m now going to share a real example with you. It involves a short signal Quant Trader gave in December 2014.
Check this out:
The chart shows Quant Trader’s signal to short Bradken Ltd [ASX:BKN]. The entry level was at $3.35 on 2 December 2014. The exit stop for the trade was set at $4.92.
Quant Trader’s strategy for short trades involves selling into weakness. You see, the odds favour that a weak stock will get weaker. That’s the basis of trend following.
But there are no guarantees. Markets can reverse course without warning.
BKN received a takeover proposal four days after Quant Trader’s short signal. This sent the shares soaring to $4.80 — just 12 cents from the exit stop.
Now, you’d probably think it was curtains for this trade. But nothing is certain when it comes to the markets. The bid soon fell over and the share price went into a tailspin.
Have a look at this:
BKN is one of Quant Trader’s best performing short trades. The stock lost 77% of its value.
But look at the path it took. BKN didn’t fall from $3.35 to 75 cents in a straight line. The shares went via $4.80. The key to profiting from this signal was being able to hold on.
I received this email just after the takeover failed:
‘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 first 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 a highly profitable short trade. Excessive leverage forced him to exit the trade at precisely the wrong time.
Take a walk on the dark side
Sure, everyone wants to multiply their profits…
But leverage also has a dark side — it amplifies your losses. Many traders overlook this most important fact. And, like Julian, it can cost them dearly.
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.
Yes, leverage could help you make a lot of money. But it only takes a few mistakes to bring it all crashing down. 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.
Until next week,
Editor, Quant Trader
Editor’s note: Quant Trader isn’t just about buy signals — it’s also about learning. Jason, through his decades of experience, aims to give you the confidence and discipline to trade like a professional.
Each weekly update helps to develop your understanding. You can then make that knowledge your own by applying it to his system’s buy signals. That’s the best way we know how to truly learn.
Quant Trader sources all graphs and images above, unless otherwise stated.