One of the attractive features of investing with derivatives is that they offer the investor leverage. Leverage is the ability to use borrowed money to fund your trades - so that you put up less of your own cash. Your return on your investment is then magnified (both gains and losses). You might often hear that using leverage is very risky, or that you can lose a lot of money very quickly.
The people that lose a lot of money quickly using leverage are those who don't fully understand how it works, and more specifically, how to use it to their advantage. Let's go through an example to see how exactly leverage works. Imagine that a particular stock or commodity costs Rs. 100. If you use no leverage, you will pay the full price of 100 for the stock. If you use 2:1 leverage, you will pay 50 for the stock. If you use 10:1 leverage, you will pay 10, and if you use 20:1 leverage, you will pay 5.
Now let's take the viewpoint of an investor who has the option of paying the full 100, or using 10:1 leverage and paying 10. The risk of paying only 10 means that if the stock price falls below 90, he will lose his investment. Otherwise there is no difference between the two methods. So for the leveraged investor, if the stock price falls by more than 10%, he will lose his investment. What are the risks of this occurring?
Well, this depends mostly on the timeframe of the investor. If he is a short-term trader, who intends to hold his positions no more than a few days, it is probably safe to assume the stock will not fall more than 10% within that timeframe. So it makes sense for him to use leverage because then he will have extra cash available to use for other investments.
If the investor's time horizon is long term (over a year), it is probably unwise to invest with 10:1 leverage. Why is this? Because it is quite possible the stock could fall 10% in the span of a year, and then the investor would lose his investment. But this investor can still make use of leverage. What if he used 2:1 leverage instead? This means that the stock will have to fall 50% before he loses his investment. Generally we can be assured that a stock will not fall more than 50% within a year, so using 2:1 leverage is safe. So the investor benefits because he doesn't need to use as much money to get the same returns.
How do you know how much leverage is safe to use? Think about it in terms of a stop loss. If the stock cost 100, and you are not willing to lose more than 20% (i.e. you would put a stop loss at 80), then it safe to use 5:1 leverage. Rather than invest 100 with a stop loss at 80, you could achieve the same scenario by using 5:1 leverage and investing 20. Your trade would automatically close out if the stock price fell to 80. By only investing 20, you can use the other 80 towards something else (such as other investments).
Most commodity and currency futures have a margin of 5% (meaning a leverage ratio of 20:1). So to make a trade, you only need 5% of the contract value. This is a small amount - prices can easily move by more than 5% over a couple of days. I would recommend keeping aside a much larger amount for your trade - again, use the stop loss method to determine how much leverage you can use. And remember that the longer your investment time horizon, the less leverage you should use (because prices can fluctuate more over a longer time period).
Generally, commodities and stocks are more volatile than currencies, so you can afford to use more leverage with currencies than other assets. Finally, when using leverage, because there is a greater possibility of losing your entire investment, never invest more than you are willing to lose.
Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!