Don’t Fear Leverage!

The critical problem that distinguishes the differences among stocks, futures, and forex lies between the application and usage of leverage. If you were to trade the futures and forex markets with no margin, your trading experience would be more on par with stock trading. Solely because of the use of margin do the potential problems with leverage arise, particularly with investors who come from a stock background.

The goal is not to fear margin/leverage, but to respect it. Once the everyday investor changes his attitude and begins to respect leverage and learn how to incorporate it into his trading as a function of his activity, not solely as a financial savior, an entirely different approach to trading evolves.

Leverage is not an afterthought in the futures and forex market. It is the foundation of the entire industry. If it were not for the incredible amount of leverage available, sometimes 20 to 1 or as high as 500 to 1 in forex trading, we could never hear as many rags-to-riches or riches-to-ruins stories.

Webster’s dictionary defines leverage as “the use of investment capital in a way that a relatively small amount of money enables the investor to manage a relatively large value.” Leveraged investing is not to be taken lightly, though. While margin in futures is not strictly a form of borrowing, like stocks, it still can be looked at as a type of credit. And, like all credit, it comes in three ways: the good, the neutral, and the bad.

Good Use of Leverage

Good use of leverage is to purchase a home. A small down payment, along with a loan, is used to acquire the home. The investment is well worth it because homeowners benefit from a home’s increase in property value over time.

Using leverage to hedge your investments is beneficial. If your finances tied to a stock index, you might find it challenging to adjust your portfolio quickly to coincide with the market’s fluctuations. Index futures contracts allow an investor to protect his portfolio with just one investment vehicle. By using index futures, you can also avoid capital gains and unnecessary commissions, expenses that you would incur if you traded stocks or mutual funds alone.

Neutral Use of Leverage

Credit cards are a prime example of neutral leverage. You leverage your income to qualify for credit cards. This type of credit is dull because you have the opportunity to purchase durable goods that can appreciate or goods that have no real value.

Like credit cards, leveraged investing is not inherently wrong. It is up to the individual investor to devise strategies to protect him when the market moves against him. Often, this type of protection must take two forms: strategic and psychological.

The strategic form of protection involves planning. The psychological form of protection requires emotional discipline.

Bad Use of Leverage

Car purchases are the worst type of leverage. A down payment on a car typically covers license, registration, and tax. After that, you get a loan on the balance of the car’s price. Since a car is a depreciating asset, you immediately know that when you drive off the lot, you lose 50% of the purchase value.

The same can said for an “options-only” leveraged investing style. Since you have to “buy” an option up front, you have a built-in loss from day one, plus you have to worry about the option’s expiring before you can get a profit. Option sellers, however, have unlimited exposure to loss. Options are excellent tools as part of an overall investment strategy, but they are an inefficient use of leverage by themselves.

Leveraged investing does not have to be complicated. Approach it the same way you would approach personal credit-deliberately and cautiously. As markets become more volatile, investors will rely on leveraged investing to gain an edge. It will be important that the difference between good, neutral, and bad forms of leverage are understood. Once leveraged investing is perceived, it can be a useful tool for any trader.

Myth Busting

I take no pleasure in summarily knocking down each idea that may have successfully carried you in your stock investing. The goal is to help you open your eyes to the potentially bad ideas that you can carry over into trading and to show you that investing and trading in futures and forex will take an entirely different skill set and way of thinking for you to succeed.