Just Eliminate Leverage from Your Trading Account
There are numerous analytical methods people employ in their search for an edge in the financial markets. There’s momentum trading, dips buying, scalping, high-frequency trading, technical indicators, conventional patterns recognition, macro investing, value investing, growth investing and many, many others. We like Elliott Wave analysis the most, because of the deep understanding of market psychology it gives us. We’re also big fans of value investing when applied to long-term stock investments. We’ve learned through experience that when conducted properly, these two produce a positive result more often than not.
The one thing all these methods have in common is that none of them guarantee success. None of them promise to deliver a profit every time. 100% success rate does not exist in trading, nor in life for that matter. In fact, legendary money manager Peter Lynch once said that getting 6 out of 10 right is enough to put you among the best.
Achieving a 60% success rate is not that difficult. It is only slightly better than a coinflip. Yet, many who get six or more out of ten correctly still fail to make any money in the long term. Brokers are obligated to write disclaimers informing about the percentage of their clients who lose money on their platforms. It is about 70% on a monthly basis, but on a long enough timeline the success rate for traders drops to near-zero.
Why are there so few successful traders and investors? There is a plethora of reasons ranging from a lack of experience, a flawed analytical method, bad money management and low discipline. Add emotions and numerous psychological biases to the mix and we understand why so few make it in the markets.
But the single biggest reason most people fail at trading is the use of leverage. Experience can be gained, a good method can be found, money management, discipline and emotion control can be practiced and improved. That’s the learning process every market participant goes through. But none of it will matter if a single mistake can set you several steps back or outright kill you financially. And that’s what leverage always does eventually.
Given enough chances, trading with other people’s money will ruin every investor and every strategy. That’s because a strategy that can precisely pinpoint market tops and bottoms does not exist. If we’re good and experienced enough, we can only predict the buy or sell area, but never the exact price level. This means that unless we’re very, very lucky, every trading position, even the ones that end up at a profit, sits at a paper loss for some time. So in order to see it through and be able to bear the fruit of our analysis, experience and discipline, we must leave the price enough wiggle room. Every position we open needs a margin for error. The use of leverage mostly eliminates that. Even leverage of just 2:1 cuts that wiggle room in half.
Leverage can magnify the profits of successful trades. However, it can just as easily magnify losses. That’s why brokers like to provide the biggest leverage they are legally allowed to. It increases the total number of trades on their platforms, which leads to more spreads and swaps and fees for them. In other words, higher leverage means higher profits for the trading platforms. That is how companies like Interactive Brokers and Plus500 stay immensely profitable while the great majority of their clients consistently lose money.
Fortunately, there is a simple solution: just don’t use leverage. Simply forget about it. Whenever you think you’ve found a good trading setup or an investment opportunity, use nothing but your own money. This way, you won’t have to worry about a margin call. You’ll have plenty of time to wait out the usual initial paper loss until the setup starts to bear fruit. By removing leverage, you no longer have to be immediately right. What counts is being right in the end. Time will be on your side, not on your brokers’.
True, without leverage your profits on each separate trade will be smaller. However, every trader’s first priority is not to lose money. Winning comes second.
Patience is another vital part of every successful trader’s mentality. When you stop using leverage you will definitely need more of it. But sacrificing that rare big hit for a calmer mind is absolutely worth it in the long run. After all, Warren Buffett, arguably the world’s greatest investor, is a centibillionaire and it wasn’t margin trading that got him there. Rich people simply don’t use leverage. Those who do, don’t stay rich for long. In fact, a quote from the Oracle of Omaha himself pretty much sums up the message of this article:
“I’ve seen more people fail because of liquor and leverage — leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.”
Leverage creates pressure on both your finances and your psyche. Pressure to be immediately right. Pressure means more intense emotions. Emotions lead to irrationality. Irrationality means bad judgement. Bad judgment leads to financial losses. It is a recipe for disaster. Leverage is a recipe for disaster. Navigating the markets is hard enough without it. So the next time you set up your trading account, just set the leverage ratio to 1:1. You’ll not only start to trade better soon, but sleep better, as well.
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