What do you think is a trader’s greatest risk?
Many people will say it’s a market crash. Others believe the danger lies in putting too much money in the wrong stock, or taking advice from the wrong people.
Sure, these carry risk — possibly extreme risk.
But I believe there’s something that beats them all. It’s been the source of ruin for many first-time traders, millionaire professionals, and even some of the world’s biggest banks.
Do you know what I’m referring too?
You see, leverage is a swing factor that could make your fortune or wipe you out. Some traders use it with great effect. Leverage lets them take large positions for a relatively small outlay.
But for others, it’s a complete disaster. Big trading positions quickly turn into big losses. Traders who don’t fully grasp the risks can see their capital vanish in no time.
In a moment, I’m going to share a real life story of a member who took on too much risk. It’s a powerful reminder of why you should always understand the risks you’re taking.
First though, here a quick re-cap from last week.
Trading is different to games of chance
You’ll recall being put to the test. I told you that gold’s price 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 nothing fancy: buy gold with your own capital. A certain profit was waiting.
The second option was more exotic. You could use ‘contracts for difference’ — commonly known as CFDs — to gain leverage. This would enable you to magnify your returns by a factor of 100.
How did you go?
Many people opt for CFDs in this type of situation. 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 you may 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.
Have a look at the chart I showed my readers last week:
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 could take countless paths to get to where they’re going. And this could 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.
Yes, leverage could boost your returns. But it can also be lethal. Leverage could lead to an early exit — or worse still, a complete wipeout. You need to treat it with respect.
It only takes a few mistakes to bring it all undone
The gold trade is of course hypothetical. But could leverage prove as costly in real life?
Well, let me give you an actual example. It involves one of Quant Trade’s short signals.
Check this out:
This is the trade chart of a company called Bradken Ltd [ASX:BKN]. The short signal was at $3.35 on 2 December 2014. An exit stop was set at $4.92.
Quant Trader’s strategy is to sell into weakness. As I often say, the odds favour that a trend will continue. Trading with the trend is the best way I know to make money.
But no trend comes with a guarantee. Markets can reverse course without warning.
BKN is a case in point. The company got 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 might think that was the end for this trade. But it wasn’t by a long stretch. The bid for BKN fell over a few weeks later, and this sent stock into a tailspin.
Have a look at this:
BKN is one of Quant Trader’s best short trades. The end result was a 77.6% profit.
But look at the path the stock took…
The share price didn’t fall from $3.35 to 75 cents in a straight line…instead, it went via $4.80. As was the case in the gold example, 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 at the time. This member had placed a leveraged short trade on BKN after the initial sell signal.
‘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. And it can prove costly.
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 greater.
It’s possible to make a lot of money with leverage. But it only takes a few mistakes to bring it all undone. Your portfolio could take years to recover.
I’m pleased to say this story has a happy ending. I heard from Julian about a year later. He told me that his portfolio was in profit. Overcoming his early setback was a great achievement.
All traders make mistakes — I know I’ve made plenty over the years. The important thing is that we learn from them and get better. Julian appears to be doing this well.
Until next week,
Editor, Quant Trader
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