Applying Margin To Stocks To Improve Returns
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Thanks for the visit, in this video, we talk leverage.
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In combination with some of the best material and personal knowledge, I hope to provide some basics regarding leverage and the use of margin to trade stocks.
The use of margin or leverage is often frowned upon within the trading community, and in many cases, rightly so, although this is generally due to its misuse or lack of understanding.
For the few that do fully understand, leverage can be very useful indeed.
The use of leverage however is extensively used in the wider financial landscape, and more commonly accepted through home ownership in the form of a mortgage.
The basic principle is the same for purchasing a property with a mortgage as it is for purchasing a stock on margin.
If we assume a property is worth $100,000, and we use a 90% mortgage to finance the purchase, this will require us to put $10,000 (or 10%) into the deal as a deposit, and the bank would provide the remaining $90,000.
Effectively we are using a $10,000 investment to control an asset worth $100,000, a leveraged ratio of 9 to 1.
If we also assume that home prices increased by 10% the following 12 months after purchase, we would have gained $10,000 in equity. However, the ‘return on investment’ would have been 100%, calculated by dividing the $10,000 deposit by the $10,000 equity gain. This is the power of leverage.
We must not however forget that the power of leverage can work against us too, if for example home prices dropped by 10% the 12 months after purchase, we would have returned a negative 100% return on investment. An example of a double-edged sword.
The concept of mortgaging a property as way of leverage, is widely seen as an acceptable method, however when it comes to using such leverage to purchase stock, the comparative use of margin is seen as less desirable.
A common leverage ratio used to purchase stock (through a margin account) is 2 to 1, this would mean we would need $5000 on account to control $10000 worth of stock.
The problem often arises when the uninformed or overconfident trader, begin to increase the leverage ratio, perhaps using the same $5000 investment to control $50,000 worth of stock. A recipe for disaster.
This is where the use of margin differs to that of a mortgage.
A mortgage requires strict affordability checks, ensuring the individual is not over exposed. Additionally, property is seen as a less volatile asset class.
Compare this to a margin account, where the individual can decide how much capital exposure they are willing to risk, on an asset class which can be highly volatile.
But how can we use a margin account to purchase stock, with acceptable exposure and risk, whilst achieving optimal returns? Let’s take a look…
First, we need to understand the strategy, if we do not know the historical performance of a strategy over varying market cycles, leverage should simply not be used.
If for example we used a 2 to 1 leverage ratio on a margin account, we could either double the profits or double the losses. If we established that the strategy or the stocks chosen could endure a 50% drawdown at any point, we could see a 100% or more loss of capital, with demands to liquidate our positions or add additional funds, often referred to as the dreaded margin call.
There is however a way to reduce the occurrence of significant drawdown, and therefore making the use of leverage a more acceptable approach. The main factor is the use of a stop loss.
In my opinion, using leverage or margin to trade individual stocks should never be considered if you do not use a stop loss, or have historical data to analyse past performance.
Let us put this into a more practical example by using our members portfolio in combination with the use of margin.
The current portfolio is made up of 12 selections, which is a typical holding quantity for me.
When I enter a new position, my initial stop losses tend to average around 10%, with the current portfolio averaging an initial entry stop loss of 10.4%.
The average positional risk of a new trade against equity is 1.88%, meaning on average if a trade hit my stop loss position, I would lose on average 1.88% of my equity.
If at any one point all my stop losses are hit, I would stand to lose 22.5% of initial equity, calculated by multiplying the 1.88% positional risk by the number of positions.
The maximum amount of leverage I would consider at any one point is 2.5 to 1, currently I am at 2.46.
If we think about this for a moment, I’m using 2.46 leverage, if I did not use any stop losses my risk would be 246%, a huge unrecoverable drawdown and multiple margin calls along the way. But by using stop losses the likely risk is reduced to 22.5%.
This is a simplistic example based on the numbers used, however there are other factors which make this level of leverage more acceptable.
We have already mentioned historical performance and stop losses, but this example also illustrates the use of risk diversification. Spreading the risk over numerous positions is a popular risk management method.
Other factors include;
Sector diversification.
Market capitalisation.
Technical structure.
The direction of momentum.
Volume profile.
Fundamental analysis.
Market cycle.
And Discipline.
Applying or at least fully understanding all these attributes is incredibly important before considering any form of leverage, none more so than discipline and the temptation to add more risk.
2 sec pause
The reality is that the professional trader, who fully understands the risk, trade using leverage because it is an efficient use of their capital.
Common levels of leverage used vary depending on the asset being traded. Typically, using leverage from a ratio of 50:1 upwards is used for the forex markets where volatility is low, or perhaps day trading stocks with tight stop losses and zero overnight holding risk.
Ratios of 2 to 1 to perhaps 5 to 1 are used for indices or swing trading, whereas trading without leverage is usually left to buy and hold strategies where the long-term costs of servicing a margin account often outweigh the benefits.
My guess is that the 90% of amateur traders which fail to succeed, operate in these high-risk ratios, in tandem with a system in which they have limited performance history.
To back up this theory I found some interesting research which correlates higher leverage ratios with lower trading profitability. The study was based on over 13 million trades, over a year, from numerous brokerage accounts.
At the bottom of this first chart, we can see the amount of leverage applied, ranging from less than 5 to 1 up to and beyond 25 to 1. To the left of the chart, we can see how many of the traders were able to return a profit over the year measured.
Only 17% of traders were able to make a profit when they applied more than 25 to 1 leverage, whereas 40% of traders using less than 5 to 1 were able to make a profit.
It’s a shame the study was not able to break the leverage ratios down further, because I have no doubt the correlation would have continued, with profitability more likely when aligned to reduced levels of leverage applied.
A similar negative correlation existed when analysing the individual trade win rate. Again, the higher the use of leverage, the less likely the trade is to be profitable. Conversely, the less leverage, the higher the probability of success.
The clear observation to be made here, is not that the mechanics of a particular trade is altered, rather the trader behaviour has altered. The psychological impact of using higher amounts of leverage and therefore equity, amplifies the key psychological biases many traders have.
Its far more likely a trader will sell a position too early into its upward trajectory, and not see out its full profit potential, thereby going against the mantra of ‘let your profits run’, and hindering the risk/reward relationship of each trade.
Simply put, the more oversized a position the less rational the behaviour.
In summary, the use of leverage does have its place, and it can be a highly effective use of capital. But, you must have a full understanding of not only the concept of leverage, but also your strategy and personal discipline level. A lack of either can have a huge detrimental impact on your wealth and wellbeing.
I do use moderate leverage, but with complete strategy and performance knowledge, strict risk management, discipline, and many years of experience.…
Thanks for watching.
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