This is a brief introduction to margin and leverage. After the relevant terms are defined and common misconceptions are clarified I present simple formulas for calculating the trading capital size that is required for minimizing the probability of ruin when trading highly volatile markets such as ETFs, futures or forex.
Undercapitalization is the number one cause of trader failures even in the presence of a sound trading methodology. Every experienced trader knows that but, as it turns out, many novice traders are often too optimistic about their abilities and their system performance prospects in the short-term and they believe they can use high leverage and get away with an undercapitalized account. For the majority of traders who are not lucky enough, the result is a margin call and account position liquidation very early in the game. Let us start with a couple of definitions:
Margin usually means borrowed money to purchase securities. This is the usual meaning of the term in the equity markets. In the futures and forex markets, margin is the amount a trader must deposit in cash or in the form of marginable securities with a broker, on a per contract basis, before opening a position.
In the case of futures there is initial margin and maintenance margin. In the case of stocks, the initial margin is 50% of transaction value and in the case of futures it is set by the relevant exchange as an amount on a per contract basis. In the case of forex, margin can be as low as 2% or even 1% of the amount of currency exchanged. Retail forex traders can control $100,000 by depositing as little as $2,000.
Leverage refers to the use of borrowed capital, margin, or even certain financial instruments for increasing potential return on investments. Thus, a stock trader who buys securities on margin and a futures trader who posts margin to go long or short a futures contract may be involved in leveraged transactions.
One common misconception, especially amongst people not familiar with the mechanics of trading, is that futures and forex trading necessarily expose traders to high leverage. Nothing can be further from the truth. The correct assessment of the situation is that futures and forex trading can expose traders to high leverage but leverage is not necessary for participating in those markets. In order to understand the point just made, note that leverage L is defined as the ratio of assets to equity, as follows:
L = Assets/Equity
Confusion often arises when the denominator in the above equation is replaced by required margin and the numerator is set to contract value. In this case, margin is transformed directly to leverage. For example, if the S&P 500 futures trade at 900, then the value of one contract is 900 x $250 = $225,000. If the initial margin is about $28,000 then L = 225,000/28,000 ≈ 8. However, a trader need not and actually should not, have only $28,000 in his account in cash when opening a position. For example, a trader with $225,000 in his account may decide to buy or sell one contract only. In this case, L =1. Similarly, if the trader has $450,000 in the account, leverage L = 0.5, meaning that leverage can be less than 1.
The same holds in the case of forex trading. A USD account holder can put down as much as $1,000 to sell $100,000 USD for EUR. The leverage L is equal to 100 in this case. This means that a change of 1% against the position of the trade will result in a loss equal to the margin posted. It is a common misconception that forex is necessarily highly leverage trading. Again, the correct way to put it is that forex trading can involve high leverage. There is no requirement that a trader gets involved in high leverage when trading forex. Actually, a trader can have USD 100,000 in cash and exchange then for EUR. In this case, L =1 and a 1% move in favor of the trader’s position will result in a +1% gain in the account. If the trader has only $1,000, then L = 100, then a 1% favorable move will result in 100% gain. Note though that in both cases, the amount gained is the same and equal to $1,000. It is only the percent return on invested equity that differs. Thus, traders use leverage to get higher return on equity in exchange for higher risk of ruin.
The important thing to realize is that futures and forex markets offer high leverage but leverage is symmetric with respect to profits and losses. It amplifies gains as much as it amplifies losses. However, these markets do not require that any transaction involves leverage. Although this sounds trivial to experienced traders, it turns out that many people who are not familiar with the subject do not understand this simple fact.
Account capitalization determination
Each time a new position is opened, the cash amount in the account of a trader should cover margin plus any future drawdown due to price volatility. A simple method of determining account capitalization per contract traded in the case of short-term and intraday trading is by considering a volatility measure like a 14-bar ATR, as follows:
Capital = 2 × ATR × Contract value + margin
For example, if the price of S&P 500 futures is 900 and the 14-bar ATR in is equal to 1.5%, then the required capital per contract traded is:
Capital = 2 × 0.015 × $225,000 +$28,000 = $34,750
In this case, the leverage L is equal to $225,000/$34,750 = 6.47
In the case of a loss, the equity will decrease and the leverage L will increase for the next trade. A more conservative calculation of the capital per contract is given by:
Capital = f × Expected Maximum Drawdown + margin
The expected maximum drawdown (on an intraday basis) is not known is advance but it can be estimated based on historical backtesting. The factor f is a safety factor, usually set to a value between 1 and 2. The higher the value of f, the more conservative risk management will be and as a result the less the probability of risk of ruin. For example, for f =1 and expected drawdown per contract equal to $25,000 per contract, the required trading capital to avoid liquidation is equal to $25,000+$28,000 = $43,000 per contract in the case of S&P 500 futures.