Position Trading #5: Leverage
Oct 7, 2011 at 10:32 am in Position Trading by
I prefer to practice position trading in a spread betting account rather than in a regular share dealing brokerage account. It allows me to play small because there are no size-independent dealing fees and because the leveraged nature of spread betting allows me to get more bang for my buck.
Leverage and Financing
Leveraged trading means trading on borrowed money. To bet at £1-per-point on a stock index priced at 1000 should require you to deposit £1,000 into your spread betting account, but it doesn’t. The spread betting company might ask you to deposit just 1/5 of the amount (£200), although you are still “on the hook” for the full £1,000 in the event of a total meltdown.
Getting £1,000 worth of firepower for a £200 deposit might be useful to you if you don’t have much available cash (but you must have it somewhere) or if you want to make a little money go a long way while diversifying. With a £1,000 deposit leveraged five times you could establish five separate positions notionally worth £1,000 each.
The spread betting provider is effectively lending you money to leverage up your positions, and for this they charge a fee in the form of rolling financing charges. In the current low interest rate environment these financing charges may not be too onerous compared with the leveraged gains that are possible on low-riced stocks.
Leverage Need Not Be Dangerous
Many people fear leverage because they have been burnt by not realising that a £1,000 deposit actually means a £5000 risk. But it should not be rocket science to figure out that if you really only want to risk £1,000 then you can simply deposit the lower £200 in the first place!
Many people fear leverage because they don’t realise that they can further limit any damage by applying a stop order to a leveraged position. Placing a stop order at 20% (it’s an example, not a suggestion) below your entry price reduces your risk by a factor of five.
In a nutshell:
A £1,000 “investment” leveraged up to £5,000, with a stop order at minus 20%, places £1,000 at risk; which is exactly the same as a traditional £1,000 ‘investment’ with no leverage and no stop order.
Platform Provider Risk
I’ve never had to prove this in court, but I reckon that operating via a leveraged spread betting account helps to protect you against losing all your money — even temporarily – if the trading platform owner itself goes bust. When allowing you to trade with the equivalent of £5,000 the platform provider is holding (and could run away with) only £1,000 of your cash.
Note, however, that I’m only talking about the platform provider risk here. If you leverage your £1,000 up to £5,000 then you’re still on the hook for the full amount in the event that your trades turn bad!
Tony Loton is a private trader, and author of the book “Stop Orders” published by Harriman House.