Boasting initial margins ranging from 5 to 15 percent, the futures markets are a paradise for traders interested in maximizing the potential of their risk capital. Unfortunately, the added purchasing power can compromise the viability of any strategy, no matter how strong.
Let’s take a look at how piling on the trading leverage isn’t always the best way to secure market share.
The Not-So-Well-Known Pitfalls of Leverage
Pretty much everyone in the market understands that the primary downside to enhanced trading leverage is the added risk. However, many of the ways in which this risk manifests itself are obscure. Here are a few of the lesser-known issues that plague traders who “go for broke” on a daily basis.
Peril #1: Extraordinary Short-Run Performance
Futures trading is one of the only professions in which you can experience resounding success immediately after getting started. You can’t perform heart surgery without 15+ years of training, but almost anyone with risk capital, computing power, and an internet connection can begin trading futures.
The low barriers to entry give legions of unprepared individuals the ability to trade quickly. And, for the lucky few, a period of “beginners luck” and large capital gains are experienced. In many cases, the extraordinary profits are attributable to an aggressive use of leverage.
Unfortunately, immediate success often leads to trader hubris and the temptation of taking on more risk. While making money in the markets is rarely a bad thing, winning big right off of the bat can reinforce reckless behavior and undermine any chance of long-term success.
Peril #2: Increased Transaction Costs
In futures, the “all-in” per-round-turn pricing model assigns trading costs on a lot-by-lot basis. Essentially, the cost of executing a trade increases 100% for every contract traded. This runs contrary to other securities, such as stocks, where it’s possible to pay only a flat fee for every trade placed, regardless of how many shares are involved.
To illustrate, assume that your broker’s all-in per-round-turn fee structure is $5.00 for one contract of the E-mini S&P 500. If you trade one lot, you pay $5.00; two, $10; three, $15; and so on. In the event your trading strategy is based upon taking small profits, then the increased leverage of multi-lot positions can cut into profitability substantially.
Peril #3: Magnified Slippage
One of the largest foes active traders face is slippage. Slippage is the difference between your desired price and where your order is actually filled at market. It’s almost impossible to fully quantify, making the cost of slippage a persistent unknown.
However, one thing concerning slippage is certain: As leverage increases, so does its impact. If you’re losing two ticks per one lot traded to slippage, then a three lot trade will cost you six ticks, or more!
Peril #4: Capital Exhaustion
For the vast majority of futures traders, risk capital is a finite commodity. Accordingly, as leverage is heightened, capital reserves are placed under pressure. While not always a bad thing, a highly leveraged trading account can produce several unintended consequences:
- Reduced staying power: Greater leverage bolsters tick value and margin requirements. When trading size, profitable positions are often closed out prematurely due to a temporary and unfortunate swing in price action.
- Strategic compromise: Employing ultra-tight stop losses and taking profits too early are practices common to over-leveraged positions. Unless these operations are included in the trading plan, they will likely eliminate any shot at long-run success.
- Increased opportunity cost: Holding large positions in the market is capital intensive. Tying up the bulk of your capital on a single trade can lead to missing out on solid opportunities in other products or markets.
Sooner or later, the perils of haphazard risk taking become undeniable. No matter how much good fortune a trader has, factors such as increased slippage, transaction fees, premature position liquidations, and opportunity cost can crush any strategy. Before ever entering the markets, it’s critical to have a concrete plan guiding your use of futures trading leverage.
Understanding How Trading Leverage Impacts Your Strategy
If you’re frequently being forced into using ultra-tight stops, experiencing high slippage costs, or constantly exiting trades prematurely, then your trading leverage is too great. A reevaluation of trading goals, available resources, and strategic considerations is in order.
For an honest appraisal of your approach to the futures markets, contact the pros at Daniels Trading. With decades of experience in the industry, the Daniels Trading team has seen it all, from high frequency scalpers to long-term investors. If your strategy involves buying an
