Leverage Trading Strategy (Margin Call, Risk, Ruin, Performance Analysis)
A leverage trading strategy is a trading strategy that makes use of leverage for the execution of its trades. Financial leverage is the possibility of opening market positions using only a part of the necessary capital.
“Give me a lever and I will lift the world for you!” Is this statement also valid for trading? How can we apply leverage to trading? We will answer this and other questions in this article. We will also look at how leverage affects a trading strategy.
In this article, we backtest a profitable trading strategy and show you at which inflection points you would get a margin call (and lose it all).
What is leverage?
– Give me a lever and I will lift the world for you!
This was said by Archimedes, a scientist and philosopher born in Syracuse in 287 BC. From a scientific point of view, it means, in simple terms, that it doesn’t matter having a lot of strength or making great efforts to move heavy objects. We need to use our strengths intelligently.
In trading, strength is capital. The main skill of a trader is his ability to make the best use of capital with the aim of increasing it.
To do this you need to have a clear trading strategy, which does not only mean knowing when to enter the market and when to exit, but also how much capital to allocate for each trade. This aspect is the topic dealt with by money management which is made up of two fundamental and inseparable areas: risk management and position sizing.
One aspect of money management is the use of leverage. Financial leverage involves buying an asset using only a part of its economic value. The broker will lend the remaining part. The part of the money that is used is called the margin.
For example, I buy $10,000 of stock X, but only invest $1,000. In this case, the margin is $1000 and the financial leverage used is equal to 10 ($10000/$1000), (purchased value) / (capital employed), in this case with $1 I buy the equivalent of $10 of the stock X.
To compensate for the lent money, the broker charges the trader an interest rate on this sum. This interest rate is tied to the interest rate of the currency in which you trade. In times when central bank interest rates are low, close to zero, then this is an irrelevant cost to consider, but now that interest rates have risen, then it may need to be considered.
Some brokers allow the trader, within certain limits, to choose for each trade which level of leverage to use, while other brokers impose a predetermined level of leverage. But now let us try to answer another question.
Why use leverage?
Using financial leverage is useful for making the most of capital. The capital available is limited, and if it is not all invested in a single trade, then the remaining part can be used to open other positions. It’s a matter of opportunity: being a successful trader implies knowing how to take advantage of the opportunities that the market offers, but if you invest all your capital in a single operation, many of them will be lost.
Returning to the above example: if I have $10,000, using leverage, I will be able to open multiple positions of $10,000 each. And since the first rule for a trader is to differentiate, being able to open multiple positions at the same time is essential.
Another reason to use financial leverage is to be able to operate on instruments that otherwise could not be purchased, such as futures contracts. An e-mini futures contract, whose underlying is the S&P 500 index, has a value of $50 per point, so at today’s prices, its value is around $200,000.
Without leverage, it is difficult for a retail trader to trade. There is indeed a micro version of such a contract whose point is worth $5, but it is less efficient because the tick-size is 0.25 points instead of 0.125, and this fact can have significant negative repercussions on slippage costs in many strategies.
Now consider another fundamental aspect: having a margin account with a broker is a necessary requirement if you want to open short positions. Trading systems that trade short are rarer than those that trade long, but if you want to have equity curves that rise more linearly, you need to have these investment strategies in your trading system portfolio as well.