Sunday, July 1, 2012

The Power of Leverage

Investopedia defines leverage as "The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment."

" Leverage can be created through options, futures, margin and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10."

Traders understand the power of leverage very well since it is the use of leverage that can provide above average returns to traders. But,leverage is a double edged sword.  Just, as it can provide above average returns, it can also provide rather quick destruction of trading capital.

On last Thursday, I had taken bullish positions in the Nifty, a position which was explained repeatedly over CNBC, so I will not go into the explanation. Most of the positions were in 5100 July calls. Some were in 5400 calls. As it happened, the 5400 calls were sold on Friday at more than double the cost. That's leverage working in our favor. IF the market had opened even slightly lower, the calls could easily have become half of their cost. So, a 50% destruction of capital was possible, rather quickly.

The 5400 calls were only a percentage of the overall bullish position, and, we had to accept the real possibility that the calls could result in big losses. Hence, their volume was controlled.

My point is: As this up move continues, traders will find many opportunities of leveraging their trades to obtain larger gains. They should do it. But, understand the risk, always.



5 comments:

Pratik Mukasdar said...

Sir why dont u develop a an application of an intraday software for iphones,blackberry and the android devices as this give a new edge to trading .....pls give ur views about that...

Austin said...

Sir i had taken 5300 July Call on Thursday and still Hold that call.. what shall i do. sell on monday morning trade or hold it through the week.

Jitender Yadav said...

Respected Sir

I think the beta of an instrument matters a lot in the kind of returns we expect. Like, for example in a confirmed uptrend we should get long in high beta counters and in downtrend, short high beta counters. Long only investors switch to low beta counters during bear markets.
Brokers margin also depends upon the volatility or beta of the counter. For options, which have high volatility full amount has to be paid upfront while for currencies futures, which have low volatility margin requirement is also the lowest.

Your Fan
Jitender Yadav

gourv said...

Dear Sir,

While taking advantage of leverage in Futures,how much money at least one should have in % term.What I mean to ask is lets say the total value of the lot is 500000 but in futute 1 lot can be traded by paying 200000.So as per your experience one should have in the trading account to trade a lot.

Regards
Gourav

Bashu said...

Dear Sudarshanji,

When to use futures and when to use options?

Would it be correct to say:
---------------------------
When trend is well established and fundamentals are backing the tend, the options can be used but volumes must be controlled.

All other times futures should be used.