POSITION SIZING WITH LEVERAGE

When trading CFD's or other highly leveraged products, this is the one decision that can matter most to your P&L.

For me, this is the big one. The decision that’s responsible for more losses and account liquidations than any other. Position Sizing.

Trading leveraged indices can be an extremely rewarding venture for investors seeking exposure to the broader market movements with amplified returns. However, along with these opportunities come increased risks due to the leverage involved.

For example, for the Indices that I trade, it’s not uncommon for the Leverage Ratio to be 500:1. That is, my broker required $16 in margin to access $8,000 of product. You’re borrowing 99% of the required capital. Needless to say that this can produce very volatile P&L movements, both up and down, so you’d best be prepared. Super clear and disciplined Position Sizing rules need to be in place to survive and prosper.

THE BASICS

Understanding Position Sizing:

Position sizing is the process of determining the appropriate amount of capital to allocate to a specific trade or investment. It's a crucial risk management technique that aims to control the potential loss on any given trade. In the context of leveraged indices, where the movements are magnified due to borrowed capital, position sizing becomes even more critical to protect against significant drawdowns and capital erosion.

The Risk-Return Balance:

The allure of leveraged index trading lies in the potential for substantial gains. However, it's essential to acknowledge that leverage amplifies losses as well. As such, traders must find a balance between risk and return by carefully sizing their positions. A good rule would be, the higher the leverage used, the smaller the position size should be to limit the impact of adverse market movements.

Percent-Based Position Sizing:

A common approach to position sizing is using a percentage of your trading capital for each trade. Many experienced traders advocate risking only a small percentage, typically 1% to 3%, of their total trading capital on any given trade. This conservative approach allows traders to withstand a series of losing trades without experiencing significant drawdowns.

For example, if your trading capital is $10,000, risking 2% per trade would mean that you allocate $200 (2% of $10,000) to the trade. By adhering to this percentage-based position sizing, traders can maintain consistency and reduce the emotional impact of losses.

The next question of course is then, if I’m willing to risk $200, how many positions? Well it depends. Where is your stop loss? What’s your Risk / Reward? Assuming a Leverage Ratio of 250:1, you could execute 10 contracts (requiring ~$400 margin), and have a stop 20pts away, risking your $200 on the trade.

Volatility-Adjusted Position Sizing:

In the context of leveraged indices, where volatility can be significant, traders may also consider volatility-adjusted position sizing. This approach takes into account the volatility of the index being traded and adjusts the position size accordingly.

For instance, in a highly volatile market, traders might reduce their position size to mitigate the impact of sudden and substantial price swings. Conversely, in a less volatile market, a larger position size may be appropriate to capitalize on potentially smoother price movements.

Diversification and Correlation:

Diversification across different indices can also play a role in position sizing. Since different indices can exhibit varying levels of volatility and correlation, spreading your capital across multiple trades can help reduce overall portfolio risk.

Careful analysis of the correlation between indices is crucial. If two indices are highly correlated, it might not be optimal to allocate full position sizes to both, as this can expose the portfolio to excessive risk during correlated downturns.

Reassess and Adjust:

Position sizing is not a static process. As market conditions change and your trading capital evolves, it's essential to reassess your position sizing strategy regularly. Periodic review of your trading performance, risk tolerance, and market outlook can help you make necessary adjustments to optimize your position sizing approach.

Be Crystal your Strategy:

What is your trading strategy / plan?

Do you take one full size position at the beginning of your trade and ride until you’re either stopped or limited out? Do you take a partial position, and increase to full size as the market momentum moves in your favour? Do you take a partial position, and increase to full size as the market moves against you, thereby improving you average entry price?

Depending on the answer to these questions, your position sizing will be very different. My #1 mistake when it comes to this, is taking too large a position initially, then not having enough headroom to add to my positions when the market presents me with a better price.

Final Thoughts:

The #1 mistake I believe most traders make is getting drunk on the juice of high leverage. It is a tool for you to increase your ROI by using LESS of your capital to generate returns. It is NOT a gift from God to trade 10x more than you could previously. Do the sums at the outset.

Let’s say you have $10,000 lying around and want to put it into an index, and hold passively. You could put this into an ETF like Betashares ASX A200, where you’ll receive ~75 Shares, or you could buy an AUS200 CFD.

With $10,000 capital at your disposal, theoretically you could go LONG ~600 CFD Contracts of AUS200 at 500:1, which would give you exposure to $4.75MILLION worth of the market. I’ve done this a few times during highly volatile periods, but as a general rule, I wouldn’t recommend this.

Alternatively, you could deposit say $200 into your CFD account, purchase ~1.3 contracts (giving you the same ~$10,000 notional parcel size), and stick the other $9,800 into a high interest bank account. You now have the same exposure to the market that you have when buying the EFT, however a lot more free capital.

There are of course other factors to consider (overnight funding costs, etc), however hopefully you get my point. Use the leverage offered by these guys as a TOOL to increase your ROI, not as a green light to trade as much size as you can. It will most likely end badly if you don’t know what you’re doing.

If in doubt, reduce position size. You’ll rarely regret it, as you’ll either

a) take a profit (deal with the fact that you could have made more) or

b) be given an opportunity to scale up to your intended position sizing at a better price.

As always, reach out if you have any queries.

Cheers

Marto