Don’t Blame the Tool for Poor Performance in the Markets

Last week Boris Schlossberg had an article published on Forex Street title Leverage With Minimal Risk. You may know Boris from his appearances on CNBC and other media outlets and/or from his writing on the web. In part, the article looks to shift the blame for trader losses from broker manipulations ("shade prices, freeze quotes, run your stops or perform a thousand other nefarious tricks") to the imprudence of traders. I totally agree with that. Too many traders look to shift blame away from themselves when they lose money in the markets.

The main point Boris makes in the article, though, is that traders are destroyed by the leverage. He calls leverage "the single greatest reason for trader failure." It disappoints me that someone with such a high profile is feeding right into the media's view that forex is the realm of crazy risk takers and is not a place for responsible folks (see The High Cost of Listening to the Investment Community Talk Forex and Don’t Hate the Game, Hate the Player — Even in Forex). To demonstrate the negative impact of leverage he talks about how at 100:1 leverage it will take just one trade to wipe out a trader's account.

That sounds all well and good, but of course a broker will margin call well before the account is wiped out (and US brokers will only permit 50:1 leverage tops), so his observation comes up a little bit short of reality. In fact, the more leverage you use, the less money you'll lose if things to all the way to margin call, but that's not really the point.

Boris espouses the view of minimizing the use of leverage to reduce drawdowns, but basically what he's saying is that traders should take smaller per trade risks. After all, lower leverage implies smaller positions, which translates to lower per trade risk. The problem with tying everything into leverage, however, is that one can take foolish risks with a minimum of leverage.

Think about it. How many people lost loads and loads of money during the tech bubble collapse or as a result of the financial crisis? It's a long, long list. Considering most stock traders and investors don't use leverage, we cannot equate risk and outsized losses only with leverage. It's a function of the greed Boris mentions at the start of his article combined with other mental short-comings (like the failure to admit you're wrong) that cost those people to lose all that money. Leverage wasn't a factor.

Leverage is nothing more than the ability to take on positions larger than the value of your account (see How much leverage to use? Wrong question!). A trader can be greedy and stupid about their risk without using it.

That all said, there's no doubt that access to leverage provides the trader or investor – especially the short-term player – the opportunity to overdo the risk by an order of magnitude. This definitely contributes to trader failure rates. Leverage is a powerful tool, and like all powerful tools it needs to be used responsibly. To that end Boris provides some worthwhile guidance when he talks about having a 2% daily risk limit for his trading (see Quick and Dirty Position Sizing Rule for Traders).

My point is focus on responsible per trade risks and the leverage will work itself out without you having to give it any thought.

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