Managing Leverage

by Joseph Skibinski, Ceres Capital

Your biggest decision is always how much to initially risk in a trade. The level of risk and manner in which your are willing to incur that risk is of critical importance due to the leverage found in futures markets. Futures markets are actually considerably less volatile than the equity markets. What kills futures traders is the leverage. Equity traders need to cover at least 50% of the value of their position with their own cash and assets. Futures traders can often get away with putting as little as 3% of the value of the position down. Leverage is the double edged sword that allows futures traders legendary profits along with the opportunity for unheard of financial ruin. Imagine buying your home with 3% of the purchase price down. It's a great deal until the price drops by 10% and your own it under water. Now if you don't need to sell your home (in futures terms, mark it to the market) you can wait things out as long as you can make the loan payments. However, if you are suddenly transferred out of town, you will owe more on the home than it is worth. Well, futures trades are marked to the market at the end of every day and often during the day. Thus, you do not have the luxury of waiting things out if the market goes against you. It is this immediacy of meeting margin requirements that secures your profits in winning trades. You know that you will always be able to cash in your winners because the clearing house requires strict adherence to exchange margin requirements. This daily mark to market is what allows you to withdraw unrealized gains from your futures account. Yes, life is much better for profitable traders!

Reducing the leverage in your account is the easiest way to address this issue. The technical term for this is "de-leveraging". It is easily accomplished by just risking less of your account in the market. A common benchmark is to never risk more than 50% of your account at any one time. A good way to insure that you do not give into temptation is to put 50% of the value of your account in Treasury Bills. If you suffer a 50% drawdown you will need to break your Treasury Bills to create the cash that the Clearing House needs to meet the mark to market for those on the winning side of your trade. Putting 50% of your account in Treasury Bills not only reduces the possibility that your account will incur a debit, forcing you to send additional funds to your firm, it also creates a decision point in your trading. Breaking a Treasury Bill is a conscious decision that forces you to reflect on your trading and possibly reevaluate your techniques. You can actually create a very save investment vehicle where you risk no more than what you have in your account and it is actually less risky than most individual stocks by going long a single Emini at 1198.00 and funding your account with $60,000. This amount covers the $59,900 contract value, a really high commission and any fees that could be reasonably incurred. The same holds true if you go long a corn contract at 206 with an $11,000 account.

This concept can be taken further by imposing diversification within the trading account. Many traders limit their exposure to any one market or market segment to 15% of their account value. Traders will reduce their overall risk exposure from 50% to 15% if they trade just a single market. Finally, most traders risk no more than 5% of their account on any single trade. Thus, in a worst case scenario, they have just under 20 potential opportunities to profit in the markets. This number drops as fees and commissions increase. Hence, their risk of ruin is their estimate of the probability that they will have 20 losing trades in a row.