Five ways you can keep your trades in gear

 
Philip Salter
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BEING able to leverage your position opens up the possibility for greater trading profits. Of course, on the flip side, being leveraged exposes you to losing more than your initial stake. However, help is at hand. If you follow some strict rules you can avoid blowing yourself straight up – giving you time to get on top of your trading game.

Simon Brown of ProSpreads explains that, on average, contracts for difference (CFD) providers ask for an initial margin of only 15 per cent if you want to trade UK blue chip equities: “This means that to have exposure to £10,000 worth of a particular share you only have to lodge £1,500 which equates to seven times leverage (10,000/1,500).” Brown says this frees up £8,500 to invest, utilise or deposit elsewhere, but he warns “should your position move against you, you will be required to deposit more money (‘variation margin’) to reflect or cover the loss that has been created by the adverse movement of the share price.”

Here, courtesy of the trading experts, are five tips on leverage to bear in mind when you are trading:

1. DON’T GO OVERBOARD
David Jones of IG Markets says one obvious tip would be not to use leverage excessively. If, for example, you have £10,000 in your account, he cautions against using it to do just one large six figure trade. It is vital that you are aware how much risk you are exposed to. Malcolm Pryor of www.spreadbettingcentral.co.uk explains: “The risk on the trade is the difference between the entry point and the stop expressed in money terms – how much you would lose if your stop is hit.” He says “that amount needs to be a percentage of speculative funds that is appropriate for the objectives and risk preferences of the trader.”

2. KNOW WHEN TO STOP
Without the right money management, a couple of bad trades can wipe out lots of small gains – this could lead to serious losses, as it isn’t necessarily how often you get it right, but on aggregate how much money you win and lose that is key. Malcolm Pryor of www.spreadbettingcentral.co.uk says the best way to manage risk is “to ensure before entering a trade that the exit point, if the trade doesn’t work, is pre-planned, and the stop order to exit should be placed at the same time as the trade.”

Brown says: “Over-leveraged trading positions often result in being stopped out too early and too often.” He explains: “If you have £1,500 to risk in a trade, but utilise all of it with seven times leverage then you will have to stop yourself out if the position moves 15 per cent or earlier, because you actually have exposure to £10,000 worth of stock, with only £1,500 available to risk.” He adds: “If you were trading a CFD on a foreign exchange (FX) product, you may only be required to deposit 1 per cent margin, which equals 100 times leverage.” As such, “if you deposit as margin all the money you wish to risk, then you will be stopping yourself out if the FX pair moves just 1 per cent against you, which, depending on your trading style, or indeed trading psychology, may well be too soon.”

3. DIVERSIFY YOUR PORTFOLIO
Although Warren Buffett has gone on the record opining that: “Wide diversification is only required when investors do not understand what they are doing,” the oracle of Omaha’s Berkshire Hathaway is invested in 34 companies. Jones advises traders to use leverage “to give yourself the ability to spread your risk across several open positions – so your trades are diversified and not an all-or-nothing punt on one market going in your favour.”

4. KEEP PERSPECTIVE
Not putting all your eggs in one basket means not only managing the risks attached to your individual trades, but also managing the risk of your overall position. Pryor says the total risk of all trades is best managed using the concept of “portfolio heat”: “Portfolio heat is the amount you would be worse off if every open trade immediately hit its stop. If individual risk on every trade is managed properly and portfolio heat is managed properly then managing leverage becomes relatively straightforward.”

5. KEEP WITHIN YOUR COMFORT ZONE
Jones says that “if the level of leverage you are using on a trade makes you uncomfortable then cut back.” With IG Markets, you can trade mini contracts, so if you find yourself chewing your nails and worrying about what effect the movement of one point against you is having on your profit and loss then cut back the size of the trade. Jones says: “It is difficult enough to get market direction right without getting stressed by every small move in the market.”