Are you leveraging your way to profit or risking the house?

In my previous articles I discussed two major areas of investment, leveraging or borrowing to invest and diversification, and how both investors and traders are misled by the myths surrounding these areas, which results in costly mistakes.

I will now continue the theme by talking about another form of leverage that causes more people to lose their shirts than any other. This is the area of derivatives and over-the-counter (OTC) products, which encompass options, warrants, E-minis, CFDs and futures.

This area is driven by fancy marketing from self-proclaimed gurus selling overpriced and often ineffective education, and the brokering industry. As you can guess, this hype marketing is full of myths and misconceptions that lead ordinary people into trading (also read investing) these high-risk instruments when they normally would not if they properly understood the risks.

The desire to trade these highly leveraged markets such as contracts for difference (CFDs) or foreign exchange (FX) often stems from the notion that as a trader you will become much wealthier, in a shorter period time, than from any other method of trading. While this is possible, in my experience most traders who have achieved success have done so through sheer luck rather than by applying solid trading techniques, and normally they do not last long before they lose it all.

In any market, the higher the risk, the greater the knowledge is needed to manage that risk. However, many traders or would-be traders mistakenly believe they already possess the required knowledge and skills to trade highly leveraged markets. As any trader who earns a living from the sharemarket knows, to be successful in trading using high leverage long-term requires knowledge, skill and yes, maybe a little luck – although the harder I work at my trading the luckier I become.

I am amazed at how many people attempt to trade highly leveraged markets with a trading plan that is a disaster waiting to happen, or worse, trading without a plan at all. It is not uncommon when it comes to short-term highly leveraged trading for me to find traders using a trading strategy, rule or technique out of context. It seems they learn something in a book or course that they think is fantastic, and rather than doing proper research and testing to determine if it works for them, the desire to make money quickly overrides commonsense and they attempt to apply it to their trading.

To me, trading is a business just like the corner shop or local hardware store, simply because as in any business you are buying/investing in something with the intention of selling at a later date for a higher price than you paid. As such, just like in any business, you need to create a business plan and test your market and your strategy, because without doing so you are taking a high-risk with the money you have invested in that business. With the sharemarket you should never place your capital at risk until you have successfully back tested your strategy on the stocks or market you intend trading.

Utilising high leverage increases reward and risk, and traders, unlike someone operating a traditional business, generally fail to properly understand the risk/reward ratio. This is because unlike running a traditional business that often seems like hard work, would-be traders get seduced by the chance to get rich quick without doing much work at all. The thing that amazes me is that although we all know that there is no such thing as getting rich quick, so many get caught up in the hype.

In my business travels over the decades I have met many brokers and other service providers from around the world and there is one thing that has been a constant and is still true today – 90% of their clients attempting to trade in these highly leveraged products end up broke or at best break even. Further, the lifespan of these people is generally anywhere between six weeks and nine months, and this is why so much emotional marketing goes into promoting new people to take up the challenge to trade these instruments.

The use of leverage can be very useful and profitable for any business, including trading the markets, however, the overuse of leverage as mentioned in one of my previous articles can increase risk and reduce returns. Understanding the realities of the market and not the myths and hype, so often perpetuated by those who are self-interested, is the first step in becoming profitable.