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How To Become A Top Trader
By Using Leverage, Margin, Net Leverage, and Reserves
How do those top-performing Market Wizards do it, making 50%-100% or more in a year? They use leverage to boost the rewards--and risks--of trading. By consistently applying a good trading system and using leverage, they take on greater risk in order to gain disproportionate rewards, as we shall see. Leverage is defined as 100% minus margin. So, of course, margin is defined as 100% minus leverage. For most established stocks priced over $4, the initial minimum margin requirement is 50%, so leverage is also 50% (that is, 100%-50%). This means we can control 2 shares of stock by putting up the cash for only 1 share, so leverage is said to be 2 to 1. After he establishes a margin account at a brokerage firm, the trader puts down margin of at least half of the total purchase price of the stock. The broker lends the trader the remaining half of the total purchase and charges interest on that amount. The initial margin requirement is usually much less for most futures contracts, making them more tempting for those wanting greater reward and risk potentials. In futures, we can use margin of 25% or less, meaning that we can use leverage of 75% or more. In other words, at 25% margin, we can control 4 futures contracts by putting up the cash for 1 contract, so leverage is also said to be 4 to 1. Margin offers both opportunity and substantial danger. Leverage is a two-edged sword that must be handled with care. It is no secret that some of the most successful traders in the world have lost more than half their trading capital in a fairly short time by using leverage of 4 to 1 or greater. Our very survival as traders requires us to avoid the temptation to use maximum leverage. Falling into the leverage trap is where many beginners go wrong. If we consistently use maximum leverage, we are likely to go broke. We must constantly employ conservative discipline designed to assure us that we stay in the game when markets turn unpredictably volatile, as they frequently do at irregular time intervals. A conservative rule of thumb dictates that, for stocks, if we use full leverage, putting up cash equal to 50% of the value of the stock as initial margin, we should keep 40% of our total capital available for stocks safely on the sidelines in cash reserves. For futures contracts, if we put up cash equal to 25% of the value of the contract as initial margin, we should keep 60% of our capital available for futures safely on the sidelines in reserves. If we take full advantage of the minimum margin requirement and put up cash equal to half of the value of our stock position, and if we get lucky and that stock price rises 50%, our profit is 100% of initial margin. We feel like a genius and will try to do the same thing again and again. But if the next stock falls 50%, our loss is 100% of margin, a total wipe out. If we have no cash reserves, we are ruined, broke, out of the game, can’t play anymore. Every once in a while, a stock actually does drop more than 50% on an overnight gap on bad news. That is why we need 40% cash reserves and diversification. For futures contracts, initial margin is the amount of money the exchange requires us to have in our account, and it varies by the specific contract. The exchanges do sometimes change initial margin requirements. Initial margin may be 10% or less; this means leverage can be a 90% or more, better than 9 to 1. It is easy to visualize how a sudden price move against our position in excess of 10% (which, again, is quite possible) can wipe out our entire initial margin. Without reserves, it would also eliminate us from the game as traders. (It would also leave us in debt to our broker, who will demand to be paid.) A Tale Of Five Traders Once upon a time, in the land of great expectations, there lived five traders. To visualize their life stories, please click on this chart link, then use your browser "<--Back" button (top left) to return to this page. The first trader, call him T0, took the conventional path. Through all the markets ups and downs, T0 stuck with the Buy-and-Hold Strategy for the S&P 500 Index. After 22 years, which included a great bull market, T0 made 846%, an 11% compound average annual rate of return. T0 suffered, however, from the stress of sitting by passively while worrying about the 49% maximum drawdown in his wealth in years 2000-2002. In contrast, all four of the other traders chose my Complete Trading System. This system is a complete set of precise instructions that goes both long and short, respects important trends, takes profits when market prices reach extremes, then reenters in the direction of the trend when the market returns to normal. This system compares favorably to the best systems known, but it is not perfect, of course. All four executed the signals from this system perfectly and without any deviation. The only difference was their different attitudes about how much reward and risk they could handle, and so they had very different outcomes, as we shall see. Trader T1 consistently traded the system using 100% margin and no leverage. After 22 years, he made 3514%, an 18% compound average annual rate of return, and he was at peace with a 14% maximum drawdown. T1’s performance was 315% better than T0’s performance (the Buy-and-Hold Strategy), while T1’s risk (maximum drawdown) was 71% less, and his reward/risk ratio was 1367% better—excellent improvements all around! Trader T2 was twice as ambitious as T1. T2 traded the system consistently using 50% margin and 50% leverage. He controlled 2 shares for every share he put up cash for, so his leverage was 2 to 1. After 22 years, T2 made 109,345%, a 37% compound average annual rate of return, but he suffered a 27% maximum drawdown. T2’s performance was 3012% better than T1’s performance, while T2’s risk (maximum drawdown) was 93% larger than T1’s, and T2’s reward/risk ratio was 1529% better than T1’s. So, T2 got much greater performance at the cost of significantly greater risk—but not proportionately greater risk relative to reward—and that is a pretty cool magic trick of leverage and compounding profits! Trader T4 was even more ambitious. T4 used futures contracts to trade the system consistently using 25% margin and 75% leverage. T4 controlled 4 futures contracts for every 1 futures contract he put up cash for, so his leverage was 4 to 1. After 22 years, T4 made 469,849%, an 81% compound average annual rate of return. T4 was widely hailed as a genius trader, and his face graced the covers of many financial publications. Oh, but he suffered two 52% maximum drawdowns, and so had to shut down a couple of accounts he traded. But with his reputation as a genius at making money, he got other chances. T4’s performance was 330% better than T2’s performance, while T4’s risk (maximum drawdown) was 93% larger, and T4’s reward/risk ratio was 22,167% better. So, like T2, T4 got much, much greater performance at the cost of substantially greater risk but not proportionately greater risk relative to reward—again illustrating the magic of leverage and compounding profits. There was yet another trader, T8, who used 12.5% margin and 87.5% leverage. T8 controlled 8 futures contracts for every 1 futures contract he put up cash for, so his leverage was 8 to 1. T8 made a lot of money but lost it very fast. He quit trading discouraged during one of his drawdowns in excess of 90%. The results of his trading are not shown in the chart. If we use maximum leverage all of the time, the odds are that we will go broke, sooner or later. Our "risk of ruin" approaches 100%. The chart and following table show the trading results of the best four traders, above. Take some time to study these figures, and you will be rewarded by valuable insights on how to become a top trader. Rewards & Risks…..%Return…Annual…MDD….2ndDD….3rdDD……R/R ..................………………..….....…............…....……..………….……….. T0 @ 100% Margin….....846……..11…......49…....41…….20...……....17 T1 @ 100% Margin…..3,514….….18…......14…....13…....12….….....249 T2 @ 50% Margin….109,345..…...37…..…27…....25…....24..……..4,064 T4 @ 25% Margin….469,849…….81…......52….…52…....45...….904,926 Definitions: T0 @ 100% Margin is the passive Buy & Hope Strategy at 100% Margin, using no leverage T1 @ 100% Margin is a Market Wizard trading system at 100% Margin, using no leverage T2 @ 50% Margin is a Market Wizard trading system at 50% Margin, using 2 to 1 leverage T4 @ 25% Margin is a Market Wizard trading system at 25% Margin, using 4 to 1 leverage % Return is Ending Equity/Starting Equity, expressed as a Percentage Change Annual is Percentage Compound Average Annual Rate of Return DD is Drawdown as a percentage of peak Cumulative Equity MDD is Maximum Drawdown as a percentage of peak Cumulative Equity 2ndDD is next largest Drawdown as a percentage of peak Cumulative Equity 3rdDD is next largest Drawdown as a percentage of peak Cumulative Equity R/R Ratio is the Reward/Risk Ratio, which is the Return/Maximum Drawdown Ratio A Disciplined Trading Plan Again, the better performing traders above chose a good trading system and executed it perfectly. The only difference was their different use of leverage. The use of leverage must be tested and built into a disciplined trading plan. Obviously, leverage must be handled judiciously. It would be beneficial to one’s reward and risk performance to find a way to use leverage only when the probabilities of success are very strong. Overly leveraged traders without a tested and precisely defined trading plan are merely gamblers who face an almost certain "risk of ruin" and have no chance of success in the long run. Sure they can win and win big for a little while, but no lucky streak lasts forever. Generally, a long series of wins and wipeout losses leaves the undisciplined trader in the unenviable position of fanaticizing that someday he will enjoy a run of unusually good luck, and then somehow quit the game while still on top. But it is only human nature that when he feels luck is on his side he does not feel like quitting when he is ahead. Traders quickly making and then just as quickly losing fortunes is a very old story repeated untold times. See the book, Reminiscences of a Stock Operator, by Edwin Lefèvre, describing the experiences of an actual famous trader, Jesse Livermore, who made and lost many fortunes using his instincts with extremely high leverage in the early decades of the 20th century. To reduce the "risk of ruin", we must have a sound plan to limit our use of leverage and keep sufficient cash reserves to keep our place at the table. It also is very useful to diversify our risk across many trades and across low-correlated financial instruments. Seasoned money managers refuse to risk more than one percent of their capital on any one trade. They can’t do that unless they adhere to strict disciplines that are well tested and designed to insure that they can stay in the game when markets turn volatile. To reduce such risks, there are many techniques that have stood the test of time. These ideas are so old that they have become cliches, but that does not mean that they can be ignored. The old masters have long recommended respecting the trends in multiple time frames, thus putting the odds in our favor and not fighting the tide. A strict loss cutting discipline also comes highly recommended, including the use of actual stop-loss orders. Never meet margin calls or average down: never throw good money after bad. Systematically eliminate losing positions and close out the worst performing positions. With a series of losses, cut back size and total risk exposure. These ideas can be back tested and built into a sound trading system. Keeping Some Fire Power In Reserve Reserves are funds in our account that are held back from trading, and usually parked safely on the sidelines in risk-less money-market instruments. The effect of holding reserves is to reduce net leverage. A workable rule of thumb that has evolved over time out of the real-world trading arena is to limit net leverage to 30%. To see how reserves, leverage and net leverage work together, employ the following formulas: Reserves = 100% - (Net Leverage / Leverage) Net Leverage = Leverage * (100% - Reserves) Leverage = Net Leverage / (100% - Reserves) where We can solve these equations to find any of these numbers. For example, for a stock position where initial margin and leverage are both 50% and net leverage is held to 30%: Reserves = 100% - ( 30% / 50% ) = 1 - 3/5 = 1.00 - 0.60 = 0.40 = 40% For stocks, if we deposit initial margin of 70% into our account and confine our use of net leverage to 30%, as recommended, then Reserves = 100% - (30%/30%) = 1 - 3/3 = 1.00 - 1.00 = 0% If we entered a futures position using 75% leverage (and, of course, putting up 25% initial margin, which represents 100% minus the 75% leverage), and if the total value of this position amounted to only 40% of our available trading capital (therefore, we are holding back 60% of our trading capital in reserves on the sidelines), then the net leverage would be reduced proportionately to 30% (that is, 75% times 40%). Using the second formula, Net Leverage = Leverage * (100% - Reserves) Net Leverage = 75% * (100% - 60%) = .075 * 0.40 = 30% Again using industry standard (and quite reasonable) rules of thumb, if we wish to keep net leverage at 30% while holding 60% of our capital in reserve, we can put up 25% margin for each contract, and therefore employ 75% leverage for each contract. Thus, using the third formula, Leverage = Net Leverage / (100% - Reserves) = 30% / (100% - 60%) = 75% It has long been known that money management is the most critical consideration in trading and investing. Money management includes the prudent use of leverage. Sound rules and disciplines allow success to accumulate while minimizing the risk of ruin. Reducing the Risk of Ruin Risk of Ruin is the probability of drawdowns in the Cumulative Equity Line of such magnitude that trading cannot continue. Sophisticated traders and investors preplan their strategies to minimize this risk. Such plans usually provide for the following: · A precise and completely defined set of instructions designed to cover any possible trading circumstances. · Start with enough trading capital to more than cover the worst drawdown in a blind, walk-forward simulation on all available historical data, which should include periods of unusually high price volatility. · Trade only within predetermined capital limits and risk limits, for each position and for the portfolio as a whole. · A method for increasing and decreasing risk exposure appropriately according to market conditions, including unusually volatile conditions. · A set of rules for automatically and quickly cutting losses on each position, before such losses grow large enough to adversely affect the portfolio significantly. · A set of rules for automatically reducing risk exposure during improbable adverse runs, that is, unusual prolonged and substantial drawdowns in the Cumulative Equity Line. · The discipline to execute the trading plan precisely as set forth in completely defined rules is part of the plan. We must never deviate from the trading plan on the fly. Of course, the plan may be modified, but then only after thorough additional research to prove the validity of the modified plan against historical data. Diversification Versus Concentration Diversification reduces risk, while concentration increases both risk and potential returns. We must find a workable balance between the two. Concentration is putting all your eggs in one basket. This can maximize reward, if we pick the right instrument. But if we are wrong, we can lose big too, so it is not generally recommended. Too much diversification would work against achieving very favorable results. But done in correct balance, diversification lowers the variability of the Cumulative Equity Line. Most particularly, diversification lowers the probability of a prolonged drawdown in equity, which is one of a money manager’s bigger worries. Diversification effectively spreads risk across different specific low-correlated financial instruments that are not likely to behave exactly the same way. For trading stocks, diversification can be obtained by equally weighting exposure to a variety of different sectors, such as technology, financial, health care, natural resource, consumer, capital goods, transportation, utility, and international. Note that re-balancing of portfolio weights may be necessary to preserve diversification when specific instruments have very large price moves. Adding bonds and commodities to a total trading/investing plan can increase diversification and thus lower risk further. Diversification also can spread risk across different indicator approaches, such as trend-following and trend-fading (countertrend) systems. Pyramiding: A Risky Strategy Pyramiding is adding to positions as price moves in the desired trend direction. Pyramiding is a highly aggressive trading strategy suitable only for full-time professional traders who know how to control risks and have the discipline to execute a tested plan consistently. Pyramiding should be executed only according a predetermined and tested method which includes an effective stop loss. Although pyramiding increases profits if the trend continues as hoped, pyramiding also increases losses if the trend reverses, so risk control is key. Reward/risk tradeoffs quickly turn against the pyramid trader when the price trend reverses. Because adding to positions changes the total cost of the entire position on a per-unit basis toward the last price, a quick reversal to the original entry price can result in a significant loss. And if the price changes direction quickly and steeply, such as on a gap or fast market, it can be impossible or difficult to limit risk according to plan. The signal to add to positions may be triggered at predetermined price points that confirm the trend direction. Such price points might be based on volatility bands, moving averages, a variety of trendlines, logical chart points, penetration of resistance levels, and so on. The standard pyramid, which is also known as the scaled-down pyramid or upright pyramid, starts with a large initial position and is followed by predetermined additions that decrease systematically in size as price moves in the indicated trend direction. For example, if the initial entry was for 100 shares, then as price moves to the next predetermined level add 50 more shares, then 25 more at the next level, then 13 more, for a total of 188 shares. The inverted pyramid, which is also known as the equal amounts pyramid, adds to an initial position in equal share-size increments. For example, if the initial entry was for 100 shares, then as price moves to the next predetermined level add 100 more, then if the price continues 100 more, then 100 more, for a total of 400. Here, however, the average cost per share is much higher, such that a smaller price reversal eliminates all profit. The inverted pyramid offers greater potential reward at the cost of much greater risk, as compared to the standard, scaled-down pyramid. The reflecting pyramid systematically adds to a position up to a predetermined price level, then it reduces the position systematically as the trend continues, so the reflecting pyramid is not a pure trend following method. If the price does have a major move in the indicated trend direction, the reflecting pyramid would result in less profit than both the standard and inverted pyramids. The maximum-leverage pyramid keeps on adding maximum size up to the limits of accumulated profits and margin requirements. This is the most aggressive strategy possible, and it offers the maximum potential reward, the maximum potential risk, and the worst reward/risk ratios. This pyramid must be combined with tight exit rules, or else it is a formula for near-certain ruin. Copyright © 2002-2010 by www.robertwcolby.com. All rights reserved. Except as permitted under the United States Copyright act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of the publisher. Reprints are available, click here.Trading and investing involve risk of significant loss. Your use of this site means that you have read, understood, and accepted our .DisclaimersEND OF PAGE return to home page: www.robertwcolby.com |