Nick McDonald: Is leverage good or bad?

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Leverage in trading is a good tool for those who use it properly. It is even better than good, it can be great. The people using it can be bad, due to inexperience or greed or otherwise - but don't blame leverage.

Once upon a time, when a trader wanted to buy $50k worth of XYZ shares, that transaction cost $50k. Today, the same transaction can be made for say $5k down as margin, and then $45k borrowed with a daily interest charge attached. This is leverage in action on stock trading, usually in the form of a CFD.

Prior to leverage becoming mainstream, when a forex speculator wanted to benefit from, for example, a falling NZ Dollar, they might have moved $100k of NZD into USD, with the expectation of NZD falling versus USD. If they were correct, they would later exchange that money from USD back to NZD with the expectation that it is now worth more than the original $100k originally exchanged. Today however with leverage, that same forex speculator can access 100:1 leverage on a trading account, meaning that only 1 per cent of the money needs to go down as margin, that's $1k down for a $100k forex transaction. This is leverage in action on forex trading.

The Bad Side of Leverage

Leverage gets a bad rap for a couple of reasons, mostly unfounded. One reason is that by the very nature of trading alone, the majority of people lose money and sometimes it is leverage that is blamed for this. However, an even larger percentage of small businesses fail, yet small business is still deemed ok. Most people who play sport, never make the professional money-making league. A large number of people not succeeding in trading to the highest level is a slightly silly reason to blame leverage for their misfortune. It is a tough game to win and a high performance endeavour. There is no field where everyone succeeds, trading is exactly the same.

Leverage is bad and risky however, for those who use it wrong. Much like a drunk driver can use his or her car in a bad and risky manner - it might save on a cab fare, but the risk to life is huge. There is the equivalent of drunk drivers in trading too, many of them.

The difference is it is not illegal and they can do what they want, when they want and only lose their own money. No harm comes to anyone but them. They use leverage in a very risky way to try and short cut the learning process and get rich quick.

The drunk driver (trading equivalent):
• Has $1k in their account, places a $100k forex trade because they can. They have no stop loss to protect their risk because they don't even know what one is, plus they are focusing on profit, not risk. They risk losing their entire $1k very quickly and usually do. They complain to their broker about their losses and tell their friends trading and leverage are bad.

The sober driver (trading equivalent):
• Has $1k in their account, places a $5k forex trade. They have a stop loss that limits their risk to just $10 or 1 per cent of their total capital. They win some, they lose some, but they know that success comes through experience and in trading; experience requires capital preservation first and foremost. They tell their friends very little, they would probably only tell them back that trading is bad.

The people losing money are the ones who later claim that they don't like leverage. Those with money already have a choice whether they will use it or not. Those who use leverage to its best potential are the ones who also manage their risk first and foremost. Just because they can access 100:1 leverage, does not mean they use it. It is just there and available if they need it.

Another way to think of it is like a credit card. Person A and person B have both just had a new platinum card approved with a $25k credit limit. Person A spends it on all sorts of unnecessary treats and goodies within a week. Person B does not feel the need to spend $25k just because they can. Instead they use it for monthly expenses, accumulate some air points and pay off the balance every month to avoid interest charges and penalties.

Person A gives credit cards a bad name; they are the drunk driver equivalent. But is it really the credit card companies' fault? Person B got by perfectly fine with the same product, they appreciate the product.

Education is the Key

In all scenarios used here - drunk driving, credit cards and leveraged trading - the bad side could have been averted with some education, combined with the end user adhering to some sensible rules. The drunk driver was in the wrong, not the vehicle used for the wrong purpose. The credit card user was in the wrong, not the credit card company for provided an in-need service. And, the trader was wrong for using leverage in a risky way to try and get rich quick; it was not the fault of the broker for making the in-demand service available.

When life is at risk i.e. drink-driving, the government invests heavily in campaigns to educate on and thereby reduce such behaviour. Banks do this to an extent also for credit cards and other leveraged lending but could no doubt do more. Brokers are not immune, their job is to educate the customer on leverage and good risk management principles, thereby enabling them to survive and succeed, as compared to wipe out and become a statistic.

Nick McDonald is a New Zealander teaching everyday people how to trade the worlds markets via his company Trade With Precision.