Leverage Matters!

[InteractiveAssets]

I often here the following phrase, “If your stop loss is set it doesn’t matter how much leverage you are using.” I have heard numerous people say this or similar things. Though I get why people think this is true, I strongly disagree with it! Stop losses are great and important to consider, but by no means eliminate the need to keep leverage in check.

Of the strategies on the C2 “Old-Timers” board the average leverage use is 3X. Very few strategies using 5X leverage or more have survived for 3 years or longer. I believe this is because too much leverage makes it very difficult to succeed in the long term.

To demonstrate, in the following charts you can see in blue the return of buying MES at open and selling MES at close. This is a proxy benchmark for day trading.

Then in orange in each graph you can see the same thing but with a 3% stop loss of NLV of the strategy applied and various leverage factors ranging from 1 to 15.

Leverage can certainly help amplify returns. However, too much leads to bad results overall by either making per trade losses larger or by increasing the number of trades that hit the stop loss.

This is part of the reason why out of the strategies that have survived for 3 years or longer on C2 you rarely see daily leverage use exceeding 5x. The average of those survivors is only 3x. Interestingly of the leverage factors checked in this demonstration the best overall return for the period was 3X.

Of course the amount of leverage that is appropriate will change based on the instrument being traded. For example, the appropriate leverage use on stocks will be very different than short term US government bonds.

Leverage is by no means the only thing that matters, but it is certainly one of them. There are obviously better strategies than just buying at the open and selling at the close (assuming you haven’t been stopped out). My point isn’t to recommend one of these strategies. My point is just to demonstrate that leverage matters. Too much of a good thing is a bad thing!

If you want to check my numbers or check other leverage factors enjoy: Excel File

1X Leverage and 3% NLV Stops vs Day Trader Benchmark

3X Leverage and 3% NLV Stops vs Day Trader Benchmark

5X Leverage and 3% NLV Stops vs Day Trader Benchmark

10X Leverage and 3% NLV Stops vs Day Trader Benchmark

15X Leverage and 3% NLV Stops vs Day Trader Benchmark

[ForexStar2]

@InteractiveAssets

Then in orange in each graph you can see the same thing but with a 3% stop loss applied and various leverage factors ranging from 1 to 15.

How can you possibly “change” the leverage (from 1 to 15) when the 3% stop is set in advance and you are using the same capital in each case?

It is mathematically impossible.

[InteractiveAssets]

If you have a $10,000 account that buys 1 MES contract versus one that buys 5 MES contracts your C2 leverage factor is different. You can in both cases have your stop set to a max loss of 3% or $300. Obviously, the amount the S&P has to drop to trigger the stop loss for 3% of NLV would be different depending on how many contracts are held.

[ForexStar2]

@InteractiveAssets

If you have a $10,000 account that buys 1 MES contract versus one that buys 5 MES contracts your C2 leverage factor is different

If you buy 5 MES contracts (instead of 1) then you are using a 15% stop, not a 3% stop anymore!

Here you are not “increasing” leverage, you are simply increasing the size of your stop and this is not what we are talking about.

If you have
capital = C,
stop in points = P (10 points for instance)
Stop in percentage = S (say 3%)
Then your system will buy/sell exactly X contracts, so that if your stop P is hit then your loss (S) won’t be greater than 3%.

It is mathematically impossible to be “highly leveraged” if your maximum loss per trade (3% in this case) and your stop (in points) are known in advance, because your maximum loss per trade will always give you the right number of contracts to trade.

And again, leverage has nothing to do with risk per trade. You can use a 100: 1 leverage (most Forex brokers offer that kind of leverage) and still risk only 1% of your capital on each trade.

[InteractiveAssets]

For example on a $10,000 NLV the stop is set to be at a $300 max loss. The price that the stop needs to be set at to equal that changes based on how many contracts are held.

[InteractiveAssets]

This screenshot below is an example for a single day to demonstrate the calculations. If you aren’t convinced after thoroughly looking at it and the excel sheet linked above, I am probably out of methods to convince you of the danger.

If you continue to disagree that leverage matters and too much can make a winning strategy lose even with stop losses in place, so be it. You have every right to believe so and trade that way, even if I think you really shouldn’t.

I would love to see you prove me wrong by creating a system using MES and 38 times average daily leverage like the strategy you started a few days ago. From your previous posts it sounds like you are going to give it another shot with similar amounts of leverage. I really think you shouldn’t, but to each their own.

By day trading MES with an average daily leverage use of 38 and stops set to 3% of NLV for the strategy your benchmark is essentially what is shown in orange below. I feel like you are playing with fire, but if I can’t convince you that you aren’t then by all means carry on.

Good luck!

[ForexStar2]

@InteractiveAssets

This screenshot below is an example for a single day to demonstrate the calculations. If you aren’t convinced after thoroughly looking at it and the excel sheet linked above, I am probably out of methods to convince you of the danger.

Oh, OK, thanks to your screenshot now I get it, I see where your problem is, give me a moment and I will explain your error.

[InteractiveAssets]

I am certainly curious to see what I calculated wrong in this screenshot.

[QuantTiger]

There was a study about leverage, and it determined 3x was a good amount if you want aggressive (4x was too much). This is in regards to the 3x ETFs like TQQQ, etc. I can’t find the link now, but it’s good your results kind of match that.

[InteractiveAssets]

Great point. I have seen things like that. I think that is part of the reason regulators have allowed 3X ETFs but don’t allow 10X etc.

[ForexStar2]

@InteractiveAssets

I am certainly curious to see what I calculated wrong in this screenshot.

I will give you a hint…

Look at your “Stop Price Needed” column.

This column should not exist in the first place.

Why?

Because the stop (in points) is ALREADY known in advance and does NOT change.

EVER!

Stay tuned for full details.

[InteractiveAssets]

Show me the math for that date of 7/12/22 with a $10,000 account going long at open with 1 contract vs 5 contracts. By my calculations those are the stop prices needed to exit if a $300 loss occurs in each scenario (3% drawdown of NLV).

[ForexStar2]

@InteractiveAssets

Show me the math for that date of 7/12/22 with a $10,000 account going long at open.

That’s precisely what I intend to do next.

[ForexStar2]

You are a very clever man InteractiveAssets, you are using a Buy-at-the-open and Sell-at-the-close S&P 500 system that does not use a fixed stop (known in advance) just to prove that “high” leverage strategies are “dangerous”.

Well, sorry but it does not work this way. In fact real traders never trade that way because a strict money management protocol requires a least two extremely important parametrers:

1: A “physical” stop, in points or $ (15 points, or $2.75 for instance).

2: A percentage stop. That percentage stop represents the maximum loss per trade that the trader is willing to accept (1%, 2% or 3%, for example).

In your example, you are simply changing the number of contracts (from 1 to 5) and THEN you decide what physical stop the system should use?!?

No disrespect (and this has nothing do with you) but only newbies, amateurs, rookies, total fools and/or traders who just knocked down half a bottle of Scotch trade that way, period.

Why?

Because the physical stop MUST be clearly defined in advance. If that stop is hit then the logic behind the entry is no longer valid and the position must be liquidated.

The trader cannot simply open a position and then say something like this :
“Hmmm…let’s see here…I am risking 3% of my capital on this trade so my stop should be located… here.”

The physical stop must be known in advance. It is entirely dictated by the specific logic of the system itself. It is NOT something we calculate after the fact just to accommodate the maximum loss per trade percentage.

If my capital is $10 000, my physical stop is 10 points ($50 per S&P 500 micro contracts) and my maximum loss per trade is 3% ($300) then I can only trade six (6) S&P 500 micro contracts!

I cannot trade 7 or 13 or 3000 contracts, I can only trade 6 contracts exactly and that’s it!

A system cannot be “highly” leveraged it the trader is always risking 3% or less per trade, it is mathematically impossible.

In fact this whole definition of leverage (nominal value of the financial instrument divided by trading capital) is completely outdated.

Real leverage is total value of the financial instrument you are controlling divided by margin required to open the position.

If you need $100 K down payment (margin) to buy a $1 million house you are using a 10 to 1 leverage , end of story, regardless of how much money you have at the bank.
If after a year the price of the house is $1,100,000 (a 10% increase) then you can turn around, sell the house and make $100 K , a 100% profit on your $100 K down payment (margin). A 10% move created a 100% profit thanks to this 10 to 1 leverage.

[InteractiveAssets]

Both trades risked only 3% of NLV. I don’t see your problem. Do the math on July 12th please.

[InteractiveAssets]

Say you were to enter a trade long MES at open on 7/12 for a $10,000 account what would be the stop logic for you.

[ForexStar2]

@InteractiveAssets

Both trades risked only 3% of NLV.

Yes, but you completely overlooked the first important money management parameter : the physical stop.

You cannot change the size of that physical stop. Again, it must be known in advance.

[InteractiveAssets]

Say you were to enter a trade long MES at open on 7/12 for a $10,000 account what would be the stop logic for you and how many contracts would you buy?

[ForexStar2]

@InteractiveAssets

Say you were to enter a trade long MES at open on 7/12 for a $10,000 account what would be the stop logic for you.

I will never trade a system if the physical stop is not known in advance.

And you cannot decide where to put your stop based on the maximum loss per trade alone, you need both a physical and a percentage stop to calculate the safest number of contracts to trade (to avoid this “high” leverage situation you are talking about).

[InteractiveAssets]

Well seems like we are getting nowhere. Maybe the next system you try running will work. I dare you to use daily average leverage of 38 or greater…just not if anyone has real money tied to the trades. Or better yet, listen to the warnings by me, the SEC, collective2, etc. Good luck and goodbye.