This post originally appeared in FutureSource’s Fast Break Newsletter on April 23, 2010, where Craig Turner is a regular contributor on various futures trading topics.

Common Questions Asked by New Traders

As a Commodity Futures & Options broker for both self-directed online and broker-assisted trading, the top two questions I am asked by new traders are:

1. What is the biggest mistake traders make?
2. What is the most important trait of successful traders?

Interestingly, but not surprisingly, both answers have to do with understanding and effectively using leverage.  Traders who ultimately lose never fully understand how leveraged their account truly is, while successful traders know exactly how much leverage they are using and are well aware of their “risk of ruin.”

Many traders are very surprised at this response.  They think the most important part of trading is picking the correct direction of the market, having a trading plan, or being disciplined traders.  They think improper risk management is a trader’s biggest mistake.  While all of those are important, they just don’t hold a candle to properly using leverage.

Traders can get away with making mistakes in picking the direction in the market, not having a formal trading plan, losing discipline from time to time, and being liberal with their use of risk management.  However, not understanding, or taking into account, the leverage of an account will catch up with you.  And it always ends badly… always

Common Leverage Mistakes and Examples

Using Margins as a Guideline for Positions

Many new traders think Margin is the amount of available funds you need in your account to hold a position.  While technically this is true, the reality is Margin levels are used by clearing firms and brokers to identify accounts that are at high risk of being debit.  If you find yourself on Margin Call, you are in serious risk of blowing out your account.  If you find yourself repeatedly on Margin Call, you need to stop trading, close your account, and never look back.

Overleveraging a Winner Into a Loser

This is probably the single most frustrating experience for any trader.  Let’s say the trader picks the right direction in the market.  The market temporarily goes against the trader and he is forced to take a loss because the market is eating up too much of his capital.  Right after the trader gets out of the position, the market goes the trader’s way and it is a big winner.

The trader was most likely overleveraged for the position.  If he was using less leverage in the account he would have been able to stay in the position.  However, it is not just the leverage that is a problem; it is realizing how much pain the trader is willing to take even before he gets into the position.

Let’s say Gold is trading at $1100.  The trader has a $15K acct and is long 2 June Gold contracts.  Gold can easily trade to $1075 before going to $1160.  If gold goes down $25 the trader is out $5000, 1/3rd of the account, and most traders would throw in the towel.  Then Gold rallies to $1150. The trader just missed out on a $50/oz profit.

Now let’s say the trader wants to get into Gold at $1100 and thinks that even though Gold could trade to $1050, the trader also thinks it is going to $1150.  With a 15K acct the trader first needs to think “can I take $50 of pain.”  If my account goes to from $15K to $5K on a 2 lot, and we are sitting at $1050 in Gold, will I stick with it or bail?  If the trader thinks he would bail, he needs to trade only 1 lot of Gold or get into Mini Gold.

Gold may never trade down to $1050, but if you think it could trade that low before reaching $1150, than you have to be very honest with yourself about the risk you are willing to take.  Some traders are very disappointed when going through this exercise.  Why?  Because they want to make $50 in Gold on a standard 100 oz contract.  However, after they go through this exercise they end up getting long the mini contract or lighten up on the lot size.  Yes, they will make less money if they are right, but they will not give up on the trade if it goes against them to $1075 or $1050.

Account Leverage Ratio

Your Account Leverage Ratio is the sum of Total Contract Value for each contract divided by the Net Liquidity of your account.  To illustrate this concept, we will go over an example for the E-mini S&P 500 contract.

Let’s say you have a $20,000 account.  You are bullish on the stock market and you want to get long the June 2010 E-mini S&P 500 futures contract trading at 1200.00.  Let’s go over a few things most traders consider before getting into this position.

Day Margin: For this example the day margin is $500 per contract.  That means with a $20K account you can trade up to 40 E-mini S&P 500 contracts ($20,000/$500 = 40) at a time.

Overnight Margin: If you want to hold overnight the margin is $5625.  So a $20,000 could hold 3 contracts without having a margin call ($20,000/$5625 = 3.55).

Tick and Point Values: Each tick in the E-mini S&P is $12.50 and each point is $50.

Let’s say the trader buys 10 E-mini S&P 500 contracts at 1200.00.  He is using $5000 in day margin (10 lots X $500) and needs to get out of 7 lots by the close since he can only carry 3 in the overnight.  The trader may be looking for a few ticks or a few points.  However, has the trader considered this?

Total Contract Value: Each E-mini S&P 500 contract at 1200.00 is worth $60,000 per contract (1200 X $50).  A ten lot is controlling $600,000 worth of the S&P 500.

Account Leverage Ratio: A $20K acct long 1 E-mini S&P is leveraged 3:1 ($60K/$20K).  If the account is long 10 contracts they are leveraged 30:1 ($600K/$20K).  A good general rule is to keep the account below 10:1 leverage even when you are the most bullish or bearish.  For my newsletter, Turner’s Take, I try to keep the leverage to 5:1, which means we are typically only using 20% of the cash in the account for margin.

Realistic Trading Ranges: On very volatile days the S&P can trade in 25 pt ranges, and the DOW can trade in a 250 pt range.  25 pts in the E-mini S&P is $1250 per contract.  For a 10 lot that is $12,500.  The $20K acct trader using 10 lots for his day trading is basically putting 60% of his account at risk at any one time ($12,500/$20,000 = 60%).  Most trading days are not that volatile.  However, who saw the Goldman Sachs fraud charges coming on Friday?  No one did and we had a 25 pt range in the E-mini S&P 500.

On a day like Friday, when the SEC announced the Goldman charges during normal market hours, many accounts were ruined.  It only takes one time for the market to go drastically against you to take out the entire account.  That is why understanding the leverage you are using and the swings a market can have on any given day is so important.

Some people may say using a stop can avoid these losses.  Unfortunately, your stop will be in the normal trading range and your account will just have a slow death of small losers until you are so frustrated you stop trading.  This is the fate of most day traders and scalpers.

The Solution

Know Your Leverage – Before you get into a trade and figure out how much you can make or lose, and how much margin you have available.  You need to look at the total contract value, the recent trading ranges and volatility for the contract, and how leveraged your account will be.  If you do not do that you are just another futures or forex account at the mercy of the next market crash or limit up/down day.

Use Spreads When Possible – Using spreads or “pairs trading” can really help out with hedging systematic risk and reducing the leverage in the account.  One of the problems with being only long or short a particular market is you are overexposed to shocks to the market and economy.  By using spreads and trading pairs you greatly reduce your systematic risk.

For example, in my Turner’s Take Newsletter we have been bullish on the stock market.  We were long the mini Russell 2000 and short the E-mini S&P 500.  This position is a great example of what understanding leverage and hedging systematic risk is all about.  We were bullish the stock market, but didn’t want to just get long the E-mini S&P 500 because it exposes us to more risk than we want to take on (just look at what happened to the stock market after the Goldman announcement).  We are big believers of hedging systematic risk whenever possible, and if you have not read our Hedging Systematic Risk article in a previous FutureSource Fast Break email, we urge you to do so at you next earliest convenience.

Hedging Systematic Risk

Instead of getting long the E-mini S&P at 1183.50, we sold the E-mini S&P at 1183.50 and bought the mini Russell 2000 at 692.50.  Why would we do this?  A few reasons:

1. In a bull market, we know that small cap stocks generally grow at faster rates than large cap stocks.  In times of economic recovery or expansion, it is easier for smaller companies to grow than larger companies.  Small companies can easily double their growth in a year or two, while it is much more difficult of for a large cap to grow that fast.  Therefore, a small cap index should outperform a large cap index in a bull market (also note the small cap index should underperform the large cap index in a bear market).
2. Index spreads have reduced margins. The margin on the S&P is $5625 to hold overnight.  The margin on the Russell is $4000 to hold overnight.  But if you have a 1:1 spread between the two, there is a 70% spread credit.  $5625 + $4000 = $9625. $9625 X .3 = $2887.50.  The margin needed to be long the mini Russell 2000 and short the E-mini S&P 500 is only $2887.50.  Why are the margins reduced?  Because spread trading related products helps reduce systematic risk.
3. If we had just been long the E-mini S&P (which is what most traders do when they are bullish on the stock market), we would be long from 1183.50.  The E-mini S&P 500 closed on Friday at 1190.25, up 6.75 pts or $337.50.  Consider we had an intraweek high of about 1210.00 in the E-mini S&P; we would have given back $1000 of a $1300 move.  While giving back profits is unavoidable in successful trading, we want to limit it as much as possible.
4. If we were just long the mini Russell 2000, we would be up about 21.30 pt, or $2130, based on our 692.50 entry and Friday’s close of 713.80.  However, the volatility of that position has been significant.  If you were only long the mini Russell 2000, there would have been almost a $2000 swing in P&L from Thursday to the close on Friday.  That kind of volatility can be difficult to handle when the markets are going against you.  It makes position and portfolio management extremely difficult.  Many futures traders exited their long Russell positions during the panic after the Goldman fraud announcement.
5. The spread “long Russell and short S&P” did not change a whole lot in terms of overall value from Thursday to Friday of the Goldman fraud announcement.  It stayed between +$1500 to +$1800 during the entire session of trading on Friday.  Obviously the market is either still bullish on the economy or everything just got sold together.  The latter is the best explanation, which is usually the case in panics (big and small).  That is why we try to spread our trading ideas whenever possible.  It prevents us from getting knocked out of a position because of a major news event.  The spread allows us to step back, reevaluate the market, and not have to make a rash decision heading into the close on a Friday.

Right now we are still bullish on equities, but we are certainly interested how trading will go for the rest of the week.  If the spread starts to weaken because small caps are being sold more than large cap stocks, that is a sign of bearish market conditions and we will consider exiting the spread.  If we do exit, it will be primarily to get flat and let the dust settle after the Goldman news.

Choosing a Broker

Regardless of whether you trade online or broker-assisted, make sure your broker has a full understanding of how to use leverage for trading.  Even self-directed online accounts need to consider this when choosing an online platform.  If your online broker is staffed with help desk support only, or worse, email support only, chances are you are not going to have the service you need when you do find yourself overleveraged.

Considering that online commission rates are about the same everywhere you go these days, having the ability to actually talk to a broker when you need him most could be the difference between blowing out your account and surviving to trade another day.  Whether you need to do a serious leverage analysis or need to get out of a limit up or limit down position before the close, chances are only an experienced broker is going to be able to get you through that situation.

Final Thoughts on Leverage

Leverage is the hallmark of successful trading as well as the single point of failure for most traders.  Anyone can pick the correct direction in the market.  However, not everyone uses leverage effectively.

Inexperienced traders usually lose because they don’t understand how important it is to have a full understanding of leverage.  They over leverage their accounts, and when you are overleveraged you create problems for yourself that are very difficult to get out of without taking substantial losses.

However, for good traders, leverage can make trading a very enjoyable experience.  For great traders, leverage is what makes them more profitable than they could have ever imagined.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.