8 Pitfalls to Avoid in Leveraged Trading

Leveraged trading can lead to massive financial losses when traps are encountered. For example, in 1998, Long-Term Capital Management (LTCM) lost $4.6 billion in less than four months due to excessive leverage and market volatility.

Similarly, in 2012, Knight Capital nearly collapsed after a trading glitch caused by leverage and a lack of adequate controls led to a loss of $440 million in just 45 minutes.

These events illustrate the severe financial impacts of leveraged trading pitfalls.

8 Pitfalls to Avoid in Leveraged Trading

Overleveraging Risks

Users make overleveraged investments when they use more borrowed money than they can afford to borrow for leveraged trading. They do so in order to increase the amount of their faith that they can lose and, therefore, the amount to be projected. However, this tactic, while attractive, also increases the magnitude of potential losses.

One of the most notable examples of the risks of overleveraged investments can be seen in the 2008 financial crisis. This period marked the ruin of many investors and financial organizations whose levels of debts skyrocketed to fund various types of investments. By using leveraged trading, these organizations created debts that they could no longer support, for instance, Lehman Brothers. After having been one of the largest financial organizations in the world, went bankrupt because it was unable to pay off the money gained from leveraged investments.

When dealing with leveraged trading, investors need to understand that the sums of potential losses may exceed their investments. Typically, an investor may choose to make an investment with a 10:1 leverage ratio. It implies that one’s investment is increased tenfold using borrowed money. Therefore, while an investor is likely to make a profit from small price changes, this trade will also expand losses. Once the market changes against your investment by 10%, you lose the entire investment and an additional amount of borrowed money. Thus, one may infer that overleveraged investments are highly unadvised, and investors need to consult experienced analysts and brokers before making such trading.

To manage overleveraging risks effectively:

  • Always perform a thorough risk assessment before entering trades.
  • Implement strict stop-loss orders to protect your capital. .
  • Continuously monitor market conditions and adjust your leverage use accordingly.

gnoring Margin Calls

Ignoring margin calls is like ignoring a smoke detector in a crowded building. Margin calls are initiated by the broker when the value of an investor’s margin account falls below the required amount . Thousands of people lose their entire investment or end up with huge losses, every day, because they either ignore or can not respond margin calls by sending more funds or closing positions. Their securities are then liquidated at a loss.

Let us consider a crude example of an investor agreeing on a leverage of 20:1, to begin trading in a volatile market. If the market takes a dip of 5% the investor has already lost 100% of his/her initial margin. This forces the broker to issue a margin call to the investor. If the investor can not meet the margin call, then the broker will have no choice but to close the investor’s position, mostly, at the worst possible time.

Ignoring margin requirements or not being able to meet a margin call have cost many investors billions and led to the collapse of very significant hedge funds and brokers. The primary example of margin requirements downfall is the Long-Term Capital Management . LTCM was an investment fund started by John Meriwether and consisted of the brightest minds in finance, including two Nobel Laureates. However, the company suffered outrageous losses during the Russian financial crisis because it had employed very high leverage ratios and was unable to respond to margin calls on time. LTCM’s downfall signified the beginning of the crumbling down of the world’s financial markets.

The risk of ignoring margin calls and the fatal damage of high leverage ratios were catalyzed by the legends of investment and billionaire, George Soros’, words, “It’s not whether you’re right or wrong, but how much money you make when you’re right and how much you lose when you’re wrong.” Thus, one never should employ leveraged positions and should always women margin call.

To effectively manage margin calls:

  • Set up rigorous monitoring systems to alert you immediately when positions approach critical levels.
  • Always have a contingency plan for funding your account quickly if needed.
  • Educate yourself thoroughly on the terms and conditions of margin trading with your brokerage.

Neglecting Stop-Loss Orders

Failing to include stop-loss orders in the leveraged trading means losing an opportunity to turn a manageable loss into a financial disaster. According to Investopedia , a stop-loss order is “a stop-loss order is an order placed with a broker to sell a security when it reaches a certain price” . In other words, a stop-loss order is a sell order of a security that is below the buying price, and the order is automatically executed when the price is reached. The idea of the stop-loss order is to limit an investor’s loss on a security position.

The most famous event that illustrates why failing to include stop-loss orders has double the danger is the Flash Crash of 2010, the day in May when the markets tumbled drastically within just a few minutes. Those traders who included their stop-loss orders in their settings had their long positions at exceptionally low prices within a couple of minutes. Thus, they did not benefit from the markets that returned to their positions just after the stock was sold.

Stop-loss orders are a double-edged sword, especially in unstable markets, which is an additional reason to include them instead of neglecting. Ray Dalio, the founder of Bridgewater Associates, once said, “If you’re not defensive, sooner or later you’re going to get your head handed to you” . The risk is especially high with leveraged trading where enormous losses are at stake.

To utilize stop-loss orders effectively:

  • Determine the right placement for your stop-loss orders.
  • Regularly review and adjust your stop-loss orders.
  • Consider using a combination of stop-loss orders and manual oversight.

Misunderstanding Leverage Mechanics

A frequent pitfall in the work of leverage for a lot of traders is ignorance of how leverage works, leading to considerable financial losses. Leverage allows traders to take on expanded exposure on the market which is not possible given the actual amount of traders’ capital.

However, for those who do not clearly understand the mechanism and the nature of such situations, it is easier to turn a potential profit into great loss. For instance, in 2015, when the Swiss Franc became unpegged from the Euro, a lot of traders that used leverage did not understand that the risk of extreme volatility was quite high.

As little as ten minutes or less, some leveraged accounts went below zero, with the rapid growth of the Franc’s value against the Euro . As billionaire investor Carl Icahn suggests, “It’s not the buying and selling that’s important; it’s the waiting” to watch . This fact applies very well in the case of leverage when the traders have to understand the work of such investments and follow their positions and investments for possible changes in the market.

To navigate leverage mechanics wisely:

  • Educate yourself thoroughly on how leverage works before entering any trade.
  • Start with lower levels of leverage while you learn.
  • Use simulation tools or demo accounts to see how leverage works in real-market conditions without financial risk.

Complacency in Monitoring Trades

Complacency is highly inadvisable in monitoring trades, especially in a leveraged environment. This is because efficient trade management entails consistent monitoring, particularly since leverage multiplies the potential consequences of market changes. For instance, the problem of complacency was evident in the case of Barings Bank in 1995 when Leeson, a trader, made unauthorized speculative trades. These trades appeared to be successful at first, resulting in complacency and a lack of enough attention from the bank’s management .

However, when the market shifted, the losses soared, which led to the bankruptcy of the 233-year-old lending institution.

The situation illustrates the urgency of monitoring leveraged trades. In the words of Warren Buffett, “Risk comes from not knowing what you’re doing.” This demonstrates the problem of complacency, as accountants may become neglectful of trades, not knowing what goes on behind their backs.

To prevent complacency and maintain rigorous trade monitoring:

  • Set up real-time alerts for all your trading positions.
  • Schedule regular intervals to review and analyze your open trades.
  • Implement a checklist for daily trade evaluation.

Poor Capital Allocation

Poor capital allocation in leveraged trading can result in great financial risks making potentially profitable strategies turning into substantial losses. Usually, this phenomenon is possible when too much capital is allocated to risky positions that are not diversified properly. The vivid historical example is the failure of the Long-Term Capital Management, a hedge fund founded in 1994.

Despite the fact that the firm hired an elite team that included several Nobel Laureates in Economics, the fund almost went bankrupt. This outcome was predetermined by nearly 100-to-1 leverages that were allocated to a range of narrow, speculative trades. Furthermore, the emotional tension reached such a high point, so the partners of the firm were not even able to speak to each other. Finally, when the Russian financial crisis occurred, the positions of LTCM fell dramatically. All those factors together forced the Federal Reserve to organize probably the most massive bailout in the history of mankind.

One of the biggest gurus of investment, Peter Lynch, once said that it is of great significance to “Know what you own, and know why you own it.” This tendency is the key to success since only the awareness of the purpose behind capital allocation and the process of allocation itself can assist in achieving particular long-term goals.

To improve capital allocation in leveraged trading:

  • Conduct a thorough risk assessment for each investment.
  • Diversify your investments.
  • Regularly review and adjust your investment portfolio.

Underestimating Market Volatility

One of the most frequent and dangerous mistakes in leveraged trading is underestimating market volatility. Traders that do not assume rapid changes in market conditions often face substantial financial adjustments.

The most iconic example of this trap is the year 2020 stock market crash. With the arrival of the COVID-19 pandemic, global markets became incredibly volatile. Traders that have been using high leverage without considering any potential swings have faced devastating margin calls and losses. For example, on March 16, 2020, Dow Jones Industrial Average suffered its worst drop in history, losing almost 3,000 points . Traders who did not expect such drastic changes and adjusted their leverage accordingly could have been liquidated out of their position at massive losses.

Thus, proper leveraged trading should respect the market’s volatility. As Benjamin Graham once put it, “The essence of investment management is the management of risks, not the management of returns.” Well-managed leverage takes volatility into account and includes strategies to optimize its impact.

Effective strategies to manage volatility in leveraged trading include:

  • Utilizing volatility indices as part of your trading strategy.
  • Implementing tighter stop-loss orders during periods of expected volatility.
  • Reducing leverage ratios in times of high market uncertainty.

Lack of a Backup Plan

Unavailability of a backup plan is potentially devastating for leveraged trading since one’s initial best-laid strategies may all fail. When an individual relies on a single trading plan in leveraged investments, they are prone to sudden market turns or changes unaccounted for in one’s anticipations. The fall of the Knight Capital Group epitomizes this scenario, as in 2012, Knight Capital lost $440 million in 45 minutes due to a technical glitch related to the trading software. The firm did not have a plan to implement should any of their technologies fail, and, thus, as a result of the technological failure, the firm nearly went bankrupt .

Warren Buffet always prescribes a metaphorical protective moat around one’s investment strategy. Though Buffett pays attention to companies’ durable competitive advantage as something viable and potentially catastrophic for an investor, it also means that investors should be prepared to defend themselves through defensive schemes such as a plan to protect oneself in times of uncertainty or unpredictable market behaviour.

To develop an effective backup plan for leveraged trading, consider the following steps:

  • Establish clear risk management protocols.
  • Diversify trading strategies.
  • Regularly conduct scenario analysis.
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