Leverage – Your best friend but also your worst enemy.

The summary which follows is in response to work I have been doing with a recent coaching client. The client, no names mentioned, has given me permission to re-produce this short summary of one aspect of his issue.

The client, lets call him Bob, had been working for many years as an investment manager for a private investment house. His investments, though conservative, had always performed well, and his own private investment portfolio had also reflected his success at investing. He felt that given his knowledge and background that he would chance his arm at trading, though much more short-term, many of the principles involved were quite similar, and his investments had always been pretty short-term in nature. He had also been spread-bet trading for the past couple of years, with some decent results.

Thus he decided that the time was ripe for him to chance his arm at trading, the investment world had been good to him, but trading would give him a chance to magnify his performance through the use of leverage, which was not available to him when investing.

Unfortunately, after two barren years however, things had not been going well, in fact he deemed it a spectacular failure, and could not see anyway to turn it around. This was despite making some decent calls on the market, and his performance with his investments, which he has continued to do in the background though in very small size only, had remained solid.

Bob was put in touch with me through a mutual friend. After listening to Bob it was clear he had made one crucial mistake. He was misunderstanding the effect of leverage on his performance. Bob had set aside a trading pool of money of around £100,000. He was using leverage of 10 to 1. Thus this gave him a £1,000,000 trading fund. Bob was fully aware that a 10% hit would wipe him out, so he traded with a maximum drawdown of 2% of his trading fund (£20,000). This would of course wipe out 20% of his capital, and thus reduce his trading fund by 20%.

Bob’s trading style, which had its source in his investment approach, relied on leaving long stops, and holding trades for at least a few days. However, whereas before when he had placed a trade, he would remain calm, he was now fearful and slowly but surely this fear started driving his trading. On many occasions he would plan a trade and then do completely the opposite, he would end up taking small profits, and cutting losing trades before they hit the pre-defined stop, which sometimes they would never actually hit. Overall he was not sticking to his trading plan or his strategy.  

The source of the problem was in the level of leverage, but the problem had now taken on a psychological dimension. Bob was now fearful of trading, his fear had damaged his trading, his confidence was suffering and his self-belief was diminishing. This usually confident, bright and extremely clever person, had slowly got sucked into the fear/negative mindset/self-doubt loop.   

As a coach, I don’t tell someone how to trade, but I try to help facilitate a better or more appropriate approach. Typically the client possesses the solution themselves, almost certainly a better solution than I may come up with, however it is usually buried deep inside their mind, and due to their problems they are rarely clear-headed enough to be able to access it. Thus my job as coach is to help the client coax the solution of out of themself.

Bob, trusted his system and his approach, however he did not trust himself. His root cause of the distrust was his fear of losing too much to continue, this was driving his trading, and fear is such a strong emotion. At the core of this distrust was incongruence between his trading style/system, personality (Bob had a conservative nature and hated uncertainty) and the amount of leverage he was taking onboard.

Bob was adamant he was not going to change his approach and style, this had always worked for him, and it was what he knew. But he was aware that the leverage levels on a method which would require some potential hefty drawdowns meant he could not possibly continue as it was.  We went through a few scenarios, and although Bob was not originally in favour of this approach, he decided to try a nil leverage approach for a couple of weeks. In other words he would just trade his original capital. The idea at that point was more about restoring his self-confidence and breaking the negative loop cycle, than generating income. – After a slow start, Bob started making money, and after a month of this was feeling a lot better about himself. – After this he decided he would trade the second month on 2 times leverage, once again this worked out well, and Bob’s confidence was really being restored.

It is now 6 months since he first went back to nil leverage. Bob has had five very successful months, with one month suffering a slight drawdown, which he was very comfortable with. – He has been using 3x leverage the past 3 months, and is preparing to move to 4x, where he thinks the right level will be for him. – I will continue to coach Bob through this process. I do not know the right level of leverage; I think only the person trading can ever know that; it is a very personal thing. He has decided that 10x leverage is almost certainly going to be incompatible with his style and method. But that he was going to try and move to a higher level of leverage, find his comfort zone, and then slowly try and push that a little further.

I have used Bob’s example to highlight how excessive leverage can and does come back to affect you in other ways. Some people can cope with it better than others, and some trading system methods are better able to cope with leverage than others. I want to make one more point clear; this is real leverage here which is being talked about, trading capital verses real capital, and not margin risk, which is often many times higher.