It cuts both ways
Our love Lev’rage is like a knife
That cuts both ways
It’s driven deep into my heart equity each time
That I realize
How it cuts both ways
Can’t be together
Cannot live apart
We’re heading straight into a broken heart
But I can’t stop

My apologies for butchering the Gloria Estefan song, but as the market fallout continues, people are finally getting a first-hand look in technicolor as to how leverage kills.
I pleaded my case in Chapter Four of Own The Zone, but the temptation is to think that the rules apply only to others, or they can be suspended with a better trading system or setup. Well, no.
This past week has seen a lot of “How did this happen to Sowood?” People wonder why hedge fund stars with all the resources at their fingertips can be “this stupid”. I can think of two reasons, and stupidity is not one of them.
First, potential investors do not want to invest in a hedge fund that promises 10% per year. They want their risk capital to return a lot more, forcing hedge funds to squeeze blood from a stone with exotic strategies. Or else they cannot get money from the client.
Second, since there is only so much return that can be had from any strategy, the only way to increase returns is to use more leverage. And of course, that cuts both ways. When it’s up, it’s up a lot. And when it is down, it is over and out.

How Leverage Affects The Individual Trader

New traders are typically undercapitalized, and tend to gravitate to highly leveraged markets such as forex and futures. This always results in wild swings in the account equity.
Leverage warps the perception of risk. The resulting reflex is to tighten stops to the point where trades tend to be prematurely stopped out, and when that happens they move to ever-smaller time frames. It becomes a vicious cycle.
Because individual traders rarely contemplate the implications of leverage, wild swings in account equity are easily interpreted as bad trading or “lack of discipline”. The blame is inevitably placed on an inadequate trading system or deficient technique, yet for some reason, few realize that they are experiencing the effects of excessive leverage. This subject was part of The Trading Clinic discussion today.
Transcript “log” for Room “The.Trading.Clinic”
[2007.08.03 10:53:46] Teresa_Lo Here is the daily chart, with the line I drew a couple of days ago.

[2007.08.03 10:54:19] Teresa_Lo So if this is a very small bear flag on the daily chart, then traders should be in the trade until yesterday’s high is taken out.
[2007.08.03 10:54:45] Teresa_Lo One thing that is hard to do is to trade a larger timeframe and manage it on a smaller timeframe.
[2007.08.03 10:57:11] Teresa_Lo You can see the trade setup on the daily.
[2007.08.03 10:57:40] Teresa_Lo But if you wish to use smaller stops, you have to use smaller timeframes. To reconcile this, one can say, “I will take pieces of that move”
[2007.08.03 10:58:10] Teresa_Lo the other thing is to just stay in the timeframe where you see the setup and trade an instrument with less leverage and smaller size.
[2007.08.03 11:05:34] Teresa_Lo In futures, we have to be mindful of the tons of leverage. There is not a lot of room for error.
[2007.08.03 11:06:16] Teresa_Lo That’s why when I trade futures, I only go for the setups that I think are surprises. I like to trade when the market is really emotional or even in panic mode.
[2007.08.03 11:06:54] Teresa_Lo We can use the leverage in futures to get us 2-3 bars in our direction and we are done. There is no need to get the home run.
[2007.08.03 11:10:06] Teresa_Lo Now when it comes to stocks or my portfolio, I use low leverage
[2007.08.03 11:10:12] Teresa_Lo and we know that trends can continue for months and months
[2007.08.03 11:10:35] Teresa_Lo so the focus shifts to capturing those big moves since we cannot afford to miss out on those opportunities.
[2007.08.03 11:10:52] Teresa_Lo We know we can mange the risks of an entire portfolio by hedging.
[2007.08.03 11:10:41] Teresa_Lo One common problem that gives people stress is that they see the setups off the daily but they try to manage the trade intraday to limit losses.
[2007.08.03 11:10:44] Teresa_Lo Well, it is hard to do.
[2007.08.03 11:11:05] Teresa_Lo The only thing is to move to a lower leverage instrument or trade smaller.
[2007.08.03 11:11:06] Teresa_Lo OR
[2007.08.03 11:11:49] Teresa_Lo if you insist on trading a high leverage instrument, the only other way is to use a smaller timeframe to take pieces of it.
[2007.08.03 11:12:17] Teresa_Lo I mean, we can see this problem all over the place. We see people who are being broken by excessive leverage.
[2007.08.03 11:12:40] Teresa_Lo In the old days, people would need a huge move to blow them out. Now, even a small move can blow them out due to the amount of leverage that is allowed by the system.
[2007.08.03 11:13:07] Teresa_Lo LTCM blew out with leverage of around 30
[2007.08.03 11:13:22] Teresa_Lo Most other hedge funds that went belly up probably were levered 20:1
[2007.08.03 11:13:33] Teresa_Lo and imagine…the average forex guy is levered…100:1
[2007.08.03 11:13:56] Teresa_Lo no matter how good he is, short of perfection, there is no way he can ever defy being ruined on one bad trade.
[2007.08.03 11:29:56] Teresa_Lo If traders used less leverage, their equity would fluctuate a lot less, and they would be able to stick to the trades.
[2007.08.03 11:30:22] Teresa_Lo I think all across the spectrum we see people who are not familiar with what leverage can do.
[2007.08.03 11:30:48] Teresa_Lo It is great when you are winning, but it is terrible when you are losing. And in the meantime, the equity fluctuates wildly, which in itself is freaky.
[2007.08.03 11:32:03] Teresa_Lo That’s why I keep it to the scalping on the index futures.
[2007.08.03 11:32:19] Teresa_Lo And in my own stock portfolio, even using 1:1 leverage, I have to be hedged or else it is just too dangerous.
[2007.08.03 11:32:57] Teresa_Lo The market is already tricky enough, but to experience emotions due to fluctuations in the equity curve is something that we should not have to worry about while we are trying to work.
[2007.08.03 11:33:23] Teresa_Lo And right now, people are finding out what leverage is all about.
[2007.08.03 11:33:27] Teresa_Lo If someone bought a house for $200K
[2007.08.03 11:33:49] Teresa_Lo put $10K down as their equity.
[2007.08.03 11:34:11] Teresa_Lo All you need is a 5% decrease on the value of the house and the equity is gone.
[2007.08.03 11:34:29] Teresa_Lo And in forex where people are using 100:1
[2007.08.03 11:34:42] Teresa_Lo a 1% move against the position means the equity is gone.
[2007.08.03 11:34:57] Teresa_Lo And there are a lot of 1% moves.
[2007.08.03 11:35:23] Teresa_Lo So they put themselves in the position where they don’t even need to experience a fat tail event to lose it all.
[2007.08.03 11:36:38] Teresa_Lo Yet somehow, they think their analysis is wrong or they need a new trading system when it is just a matter of math.
[2007.08.03 11:37:03] Teresa_Lo Maybe we are just not alerted to it enough.
[2007.08.03 11:37:11] Teresa_Lo If there is a law of financial gravity, leverage must be it.
[2007.08.03 11:37:56] Teresa_Lo So there might not be anything wrong with the analysis. Just that the higher the leverage, the smaller the move needs to be to affect the account equity.
[2007.08.03 11:38:32] Teresa_Lo For example, in futures trading, this is what I use:
[2007.08.03 11:38:51] Teresa_Lo 1 ES contract is currently worth $37K
[2007.08.03 11:39:03] Teresa_Lo the minimum day trading margin is something like $2K
[2007.08.03 11:39:17] Teresa_Lo 36:2 = 18:1
[2007.08.03 11:39:29] Teresa_Lo I have about 10K in my account for each contract
[2007.08.03 11:39:36] Teresa_Lo so I am trading 37:10
[2007.08.03 11:39:39] Teresa_Lo or 3.7:1
[2007.08.03 11:39:58] Teresa_Lo We know that my portfolio is 1:1 and I already deploy hedging
[2007.08.03 11:40:28] Teresa_Lo so in my futures trading, I am only interested in emotional, surprise scalps where I know the potential for runing stops or getting a couple of big expanded range bars is high.
[2007.08.03 11:42:20] Teresa_Lo I think the performance numbers you read on the internet are from people who are hot at the moment…and when the post their “we have never had a losing year” kind of crap…
[2007.08.03 11:42:47] Teresa_Lo you know they are probably justing an arithmetic average to get that statistic OR they are just lucky and will bust big time in the near future with near certainty.
[2007.08.03 11:43:16] Teresa_Lo In the meantime, individual traders feel inadequate if they get 12% per YEAR. They feel they have to keep up with the Joneses with 12% per MONTH.
[2007.08.03 11:43:34] Teresa_Lo But as we well know, the Joneses are living high on credit cards. LOL.
[2007.08.03 11:44:18] Teresa_Lo Or maybe what I should say is that the Joneses don’t tell us they are living large on leverage, that they stay up all night worrying…
Something to consider: If the big boys routinely get buried by overdoing leverage, can the average trader expect a different outcome?