Friday, August 17, 2012

E-Mini Trading: Leverage, the Dog That Bites

One of the most important factors in attracting new traders to the e-mini markets is the ample supply of leverage you are allowed to trade. While e-mini trading is not the most leveraged trading in the world, you'll find an average in the area of 50:1. Wow! At first glance, most traders are encouraged or excited about having the opportunity to trade an exchange traded equity with such high leverage.

There is one very important maxim that is important to remember when working with leverage; leverage maximizes your return on investment, and it also maximizes your loss on investment. Did you read the second half of the prior sentence? It's important to remember, so I will say it again; leverage maximizes your loss on investment. As you can see, I am not a huge fan of overusing leverage; many new e-mini traders exit the trading business because they overtrade or trade too many contracts.

So far, we have noted that leverage:

Maximizes the profit in a trade
Maximizes the loss in a trade
Overuse of leverage is a major cause of new trader failure
Many new traders start trading without proper training in the use of leverage

What are the parameters for using leverage in e-mini trading?

As I mentioned earlier, my observations have led me to believe that most traders tend to overleveraged themselves and hasten their exit from the e-mini trading business by doing so. My message is a simple one: it is far better to be under leveraged than overleveraged. There are several methods for calculating your level of leverage, and they are:

1. The value of one contract on the YM or ES (or any e-mini contract, for that matter) can be obtained by multiplying the index value x 5. For example, let's say the YM is trading at 12,000; the value of that contract is 5 X 12,000= 60,000. If you are trading an account with 00, you would be leveraged ,000/00, or 12:1.
2. Another way of calculating your leverage is to multiply your stop loss x number of contracts you are trading. For example, let's assume you are trading to contracts with a stop/loss of 20 on the YM. You if you were completely stopped out, your maximum loss would be 0. By using this calculation, you are putting 3% of your futures trading account balance at risk.

I much prefer the second methodology in my trading as it provides for me a more realistic value of the risk I am considering. I think it is important that you risk no more than 3 5% of your account balance on any given trade. I will again mention that when e-mini trading it is important that you consider under-leveraging as opposed to over leveraging. Just because your broker says you can trade 8 contracts by virtue of your account balance doesn't mean that you have to trade that many, or should never consider trading that many.

In summary, I have taken a moment to discuss leverage and how it affects e-mini trading accounts. We have given several methods for calculating leverage and some guidelines to observe. Finally, and most importantly, I urge your traders to trade from an under leveraged position and avoid over leveraged trading.

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