The Thing about Leverage
Leverage is wonderful and terrible all at once. The thrill of a highly leveraged position ticking up enormous profits is only comparable to the stomach churning dread of a highly leveraged position going in the opposite direction.
When you’re inexperienced and dreaming of striking it rich you’ll often crank that leverage all the way up, this is a bad, bad idea and here’s why.
Let’s say that you open a new Oil position and apply 100x leverage. If Oil moves a single percent up you’ve made 100%, but if it goes the other way by 1% then you lose 100% of your investment. Game over. Oil doesn’t often move 1% in a day, but even if it moves -0.25% you’re 25% down.
Luckily you can only use up to a maximum of 10x leverage on stocks. Has anyone traded AMD or perhaps Tesla? If you had a 10x position open on a stock and it dips by 5% then you’re 50% down. Tesla dropped 20% in one month, AMD is easily capable of the same.
Guidance on using Leverage
As I’ve previously discussed it’s impossible to time the market perfectly, you need to give yourself some margin of error when trading but with high leverage you reduce that margin to just about zero. So what are my recommendations when it comes to leverage?
- High-volatility instruments e.g. cryptos, and some stocks: 1x — 2x max. These can move anywhere between 3% and Nx100% in a short amount of time.
- Medium-volatility instruments e.g. some finance stocks, certain commodities:1x — 5x. Here we’re looking at investments that usually move a max of 3% per day.
- Low-volatility instruments e.g. indices and certain commodities:1x — 10x, and in most cases I would still stick to 1x — 5x as above. In this class the instrument shouldn’t move more than 1.5% per day maximum (I know that indices can make bigger moves, they usually don’t though).
The Cost of Leverage
Besides risk, you should also consider the fees on leveraged positions. The higher the leverage, the higher the daily holding fee with most 1x positions carrying no daily cost. If you plan to buy-and-hold for sometime you are should consider 1x as the default, and only use 2x where you expect a long-term return that easily outstrips the holding cost
What do I use?
As a rule, I use a maximum of 2x on my trades, and will use 1x where I perceive additional risk. Please be very careful with higher leverage, you could lose everything in minutes!
In addition, here’s eToro’s documentation on leverage:
When opening a trade, you can decide if you wish to use leverage or not. Different instruments have different leverage limitations:
The maximum leverage for Stocks ranges between x5 and x10
The maximum leverage for Currencies ranges between x50 and x400
The maximum leverage for ETF’s is x5
The maximum leverage for Commodities and indices ranges between x10 and x100
It is not possible to use leverage when trading Cryptocurrencies