Part 2 of 4
NEW YORK (TheGoldAndOilGuy.com) -- Mistake # 2 -- Using Too Much Leverage
With this section talking about leverage I am mainly going to be referring to futures trading because futures provides the most leverage. Anytime I talk about futures trading with someone, more times than not they either say they do not trade those things or they tune out all together because in their mind it's crazy and risky.
While there is no question that futures can be volatile at times, what individuals do not understand is that it's not the volatility of the market that causes problems. It's proven that most large-cap, big-name stocks actually have more volatility than the majority of futures contract, whether it's the S&P 500, wheat, corn, gold, oil, etc. The problem is the amount of leverage one used with their money.
The difference between trading stocks and futures is the amount of capital required to enter a trade. While this could be a very long and detailed section with examples of leverage, I am going to keep things simple and short cause it's really not that difficult.
Using an example of a trader, "Dave," who wants to trade the S&P 500 index with his risk capital, here are two examples that show how leverage drastically changed the outcome of a position.
Dave has a $10,000 account and wants to swing trade the S&P 500 index.
Option #1: He buys $5,000 worth of the SPDR S&P 500 ETF Trust (SPY). If the S&P 500 rises in value by 3%, Dave would see a $150 gain on his trade. This ETF has no leverage and follows the performance of the stock market.
Option #2: Dave decides to buy one ES mini futures contract, which is the S&P 500 Index futures contract. Using the same numbers as the previous option, the S&P 500 rises in value just 3%. How much money did Dave make on this trade? He made a whopping $2,625 on the same move that the ETF did. How is that possible?
Let me explain: when you buy a non-leveraged ETF like the SPY with $5000, you are literally only trading with a $5,000 investment. But with futures, when you buy one ES mini contract that is worth roughly $5000, you are actually controlling roughly $75,000. So think if it as 17.5x leverage on your money.
So that 3% gain in the stock market is based off a $75,000 investment ,which is how you get $2,625 or a 52.5% return on your money.
Futures trading in my opinion is not for beginner or intermediate traders. The only way your money should be involved with futures is if you truly understand how the market move and have strict money management rules, or us a system that trades and managed positions for you. Remember, leverage is a double edge sword that can make you wealthy or broke quickly if not traded appropriately.
Why Do Traders Make Mistake #2?
The simple answer is mainly because of "ignorance." I'm not saying most traders are ignorant, I'm just saying most individuals are unaware of the mount of leverage involved with futures trading or even the 2 times- and 3 times-leveraged exchange-traded funds.
People who are used to putting up $10,000 of capital to buy $10,000 of stock/ETFs often assume they are doing the same with futures. Little do they know that $10,000 position in futures is actually controlling $170,000 and in some cases up to $330,000 in capital.
Another problem is that most brokers will not tell you when you are over-leveraged. Brokers make money on trade commissions so it's not too often they tell you to trade less and watch your leverage levels.
How to Avoid Mistake #2
A way in which you can try and avoid trading with too much risk is by having the proper account and position size. The key is to use just enough leverage on your money to generate above-average returns while not exposing you to too much risk.
Of coursem trading with leverage come increased trading emotions. This is one of the reasons why automated futures trading systems have become so popular. Having system (mechanical trading system) can eliminate a vast majority of emotional and psychological issue with which we humans struggle.
Using To Much Leverage Trading Conclusion:
In short, if your trades will typically have a drawdown of, say, 20%, then you must be sure your account has enough money to be able to enter the same size position after lose 20% or your account. If you will not have enough money left to keep trading, then either adjust your strategy or deposit more capital.
To get a solid feeling of how leverage works, I suggest spending 20 minutes and play with a calculator and play with the potential gains or losses using various leveraged instruments like the 1x, 2x, 3x exchanged traded funds, and also futures contracts like the ES mini, which is $12.50 per tick, or $50 per point.
I do provide trade ideas and my position sizes for all the trades I take at my ETF and futures trading newsletter www.GoldAndOilGuy.com.
Stay tuned for Part 3 -- Failure to Control Risk
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.