Warning: Use Leverage Carefully
Tell me. What do you think is a trader’s greatest risk?
Many people will say it’s a market crash. Others believe the danger lies in putting too much money in the wrong stock, or perhaps taking advice from the wrong people.
Sure, these all carry risk — possibly extreme risk. But I believe there’s something that beats them all. It’s been the source of ruin for many first-time traders, millionaire professionals, and even some of the world’s biggest banks.
Do you know what I’m referring too?
Well I’ll tell you: It’s leverage.
You see, leverage is a swing factor that could make your fortune or wipe you out. Some traders use it with great effect. Leverage lets them take large positions for a relatively small outlay.
But for others, it’s a complete disaster. Big trading positions quickly turn into big losses. Traders who don’t fully grasp the risk could see their capital vanish in no time.
I’m going to share a real life story of someone who took on too much leverage. It’s a powerful reminder of why you should always understand the risk that you’re taking.
Okay, check this out:
This is the trade chart of a company called Bradken. I sent a short signal to members of a trading service when the shares were at $3.35. The exit stop was set at $4.92.
You see, my strategy is to buy into strength, and sells into weakness. As I often say, the odds favour that a trend will continue. Trading with the trend is how many of the best traders make money.
But no trend comes with a guarantee. Markets can reverse course without warning. And that’s exactly what happened with Bradken. The company got a takeover proposal four days after the short signal. And this sent the shares soaring to $4.80 — just 12 cents from the exit stop.
Now, you might think that was the end for this trade. But it wasn’t by a long stretch. The bid for Bradken fell over a few weeks later, and this sent stock into a tailspin.
Have a look at this:
Bradken was a standout short trade. The end result was a 77.6% profit.
But look at the path the stock took… the share price didn’t fall from $3.35 to $0.75 in a straight line. Instead, it went via $4.80. The key to making that profit was being able to hold on.
I’m going to show you an excerpt from a message I received at the time. It’s from a member of the trading service who placed a leveraged short trade on Bradken. Here’s what he says:
“I was forced to buy back half the Bradken shares due to a margin call at $4.45. The remainder I held until two days before the failure of the bid and cut the rest at $4.14. I didn’t want to hold on until the stock hit the stop loss and loose even more money. I know I over-reacted with a $4,000 position and it cost me dearly.”
I remember reading this email for the first time. I was so disappointed for Julian. He’d emailed me after the initial price surge and I was hoping he’d held on.
This is the danger with leverage. Julian lost his grip on a highly profitable trade. His forced exit took him out at precisely the wrong time.
It’s possible to make a lot of money with leverage. But it only takes a few mistakes to bring it all undone. Your portfolio could take years to recover.
Most traders think about their potential for gains — that’s only natural. But fewer give as much thought to the downside. This often leads to taking on too much risk.
So sure, use some leverage if it’s right for you. But be sure to keep it under control. Don’t let too much leverage turn the year’s best trade into a disaster.
Well that’s all for this week. If you’re watching this anywhere other than my website motiontrader.com.au then come over and have a look. That’s where I have all the free stuff. I think you’ll like what you find. And if you liked this video, or even if you didn’t, scroll down and let me know what you thought.
So until next time, I’m Jason McIntosh, and let’s find some trends this week.
I'm Jason McIntosh, the creator of Motion Trader. My career began in 1991 on the trading floor at Bankers Trust. Nowadays, I trade my own systems from home in Sydney.
Motion Trader is for investors who value robust analysis, data driven entry and exit signals, commentary, and education. I use engineered algorithms to identify when to buy and sell ASX stocks. No biases or guesswork, just data driven signals.