“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.
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.
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.
- Short Selling Trading Strategies – Is It Possible To Make Money With Shorting Systems?
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- Short Squeeze Trading Strategy — What Is It? (Example)
The margin used to open a short position has a different meaning than that used in long positions. In long positions, the margin is the money actually used at the time of opening. In short positions, the margin serves the broker as a guarantee that the trader can buy the stock and close the position even if the market moves contrary to expectations.
What is the risk of leverage?
Financial leverage involves considerable risks. Leverage allows you to increase your exposure to the market by investing more money than you actually have, exposing you to the risk that even small price movements, contrary to the position, can lead to the loss of the capital employed.
A typical broker disclaimer reads is like this:
– Trading is a high-risk activity and can result in the loss of your entire investment.
That’s because there is use of leverage. If you go long on stock X using all your money, the stock needs to go to zero to lose all your money. That is most of the time an unlikely event. But with leverage, it is different.
For example, if I buy an e-mini futures contract with a leverage of 20, it means that I invest, at today’s prices, about $10,000 to buy $200,000.
But if the price falls by 5%, the loss equals the margin (5% of $200,000 = $10,000).
The same example applies to stock trading. The fact is that an adverse movement of 5% is not uncommon, and if the margin is equal to the all capital owned, you can lose everything in a single trade. This is a risk you should never take! Remember:
– Don’t put all your eggs in one basket.
When the loss approaches the margin limit, and if the money in the investment account is greater than the committed margin, the broker can increase the margin, i.e. lock in more money to protect against a greater loss. This is called a margin call.
If there is not enough money in the account, the broker can decide to close the position, or he can send the trader a margin call, that is, the broker can invite him to pay more money into the account to increase the margin within a time limit, but still reserves the right to liquidate the position at its discretion.
When a market has a phase of adverse movements, when certain price levels are reached, further strong downward accelerations might occur. Such accelerations may be due to brokers that automatically liquidate large positions because losses have reached margin call levels.
Backtesting a leverage trading strategy
Let’s now analyze a leverage trading strategy, that is, let’s look at the consequences that financial leverage has for a trading strategy. Let’s take, for example, a well-known trading system that opens a long position at the end of the day when the three-bar daily RSI is below 30, and closes the position when the closing day price exceeds the previous day’s high:
Leverage trading strategy trading rules
This is the trading rules of the strategy:
BUY = RSI(3) < 30;
SELL = C < Ref(C, -1);
Such a strategy applied to the SPY ETF produces the following equity line:
This trading system is simple, and its historical performance gives excellent results, as can be seen not only from the equity line but also from the following statistics:
- 550 trades since 1993
- Annual Return: 8.25% (buy and hold is 7.57%) – not including dividends
- The average gain per trade is 0.46%
- 71.45% of the trades are winners
- You are invested 28.44% of the time
- Max drawdown is 23.74% (buy and hold 56.47%)
- Risk-adjusted return is 29.01% (8.25% divided by 0.2844) (buy and hold 7.57%)
The win ratio equals 71.45% is excellent. The trading system beats buy and hold, being invested only 28.44% of the time. The drawdown is lower than half of the buy and hold. All the statistics are pretty good.
Now ask yourself an important question: How far could you have pushed the leverage in this trading system?
The answer is in the trade list, where there is a piece of very important information that is often overlooked: This information is the Max Adverse Excursion% (MAE%).
MAE% indicates the maximum negative excursion the equity line has reached during the trade. You can think of the MAE% as the drawdown% of the single trade.
Here you find the MAE% of each trade summarized in the Max Adverse Excursion distribution:
The graph indicates that 50 trades out of 550 had a MAE% in absolute value greater or equal to 5%. If these trades had employed a financial leverage equal to 20 (100/5), the trades would have led to insufficient capital in the account and subsequently to forced liquidation of the position or a margin call.
Furthermore, from the Profit/Loss distribution (see next image), you can note that only 12 trades close with a loss greater than or equal to 5%, therefore it is recommended to be sufficiently capitalized to avoid incurring a forced liquidation by the broker which would act like an unwanted stop loss.
After this analysis, you can understand that this trading system is not tradable with a leverage higher than 20. The minimum margin you should have used is equal to the largest absolute value of the MAE%: in the example, it is 25%.
This value equals a financial leverage of 4 (100/25).
Another important question arises:
What is the best leverage for trading?
The best leverage value for trading is very low and such that even in the event of max drawdown, you do not run the risk of exceeding the margin and receiving a margin call.
In the previous example, the theoretical value equals 4, but this value only looked at the past. Every trader knows that the worst drawdown is yet to come, so it is more prudent to use a leverage of 3 or 2.
The level of leverage also depends on whether you are trading a portfolio of trading systems with uncorrelated financial instruments.
- What does correlation mean in trading? (Trading strategies and correlations)
- Uncorrelated assets and strategies – benefits and advantages (examples and backtests)
- Does your trading strategy complement your portfolio of strategies?
- Why build a portfolio of quantified strategies (including two strategies)
Diversification of unrelated assets is the holy grail of trading. Higher leverage may be offset when strategies are uncorrelated. However, it must also be taken into account that when the market crashes, at least in the early panic phase, the correlation between the different strategies increases.
You may also trade with a non-leveraged account, usually called a cash account. But cash account prevents you from opening short trades, and this goes against the diversification criterion. Furthermore, in a non-margin account, when a trade is closed, the money is not immediately available to open another. You have to wait three to four days to be able to use them again (the settlement period). So even if you are not trading from the short side, you can’t trade long effectively.
Leverage Trading Strategy – Conclusions
Using leverage in trading is necessary for the efficient use of capital. A low level of financial leverage increases the profitability of your capital without exposing you to too high risks (or ruin).
But the correct level of leverage depends on the mix of trading strategies you use and how closely they correlate.
Finally, operating with a non-margin account (cash account) is not advisable. If you do, it is not possible to initiate short positions and thus hard to diversify, and perhaps even worse, once a trade is closed, you need to wait a few days to reinvest the money (settlement period), hindering an efficient use of the money.
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