Reader Question

Mike, I took your quiz on Facebook, Are you an Investor, Day Trader, or Trend Follower and I had a question: What is the right answer for the leverage question?

On some level, there is no “right answer.” There’s only what’s right for you. Leverage amplifies both gains and losses, and I think if you’re starting out in the business you should focus on keeping your losses as small as possible. (You can always lose a lot of money sometime in the future, so why start now? Wait a while…) That means as little leverage as possible.

One trader I know pretty well, Linda Bradford Raschke, is known to only trade the contracts that she can pay for in full. In other words, she uses zero leverage. For example, with Feb Gold at $1,104, she would need $110,400 in her account to trade it. (Gold is 100 oz contract). I had a great interview with her a while back and I think she’s one of the best traders around.

Another way to look at it is “what type of results do you want to get?” You are in control of your equity curve. It’s your model, or lack thereof. You get to decide what type of shape your equity curve takes, it’s slope, and it’s potential for parabolic movement (it can be concave down too). Knowing that fact ahead of time, you can take your time and backtest your trading rules to see how your results FEEL to you.

If you don’t like how your results FEEL, don’t trade the model. Cut position sizes, cut/eliminate closely correlated contracts, or cut your margin/equity ratio down and backtest again. This way, when you begin to trade in real-time and you experience a draw down of X%, you might not sabotage your trading because the results are “in model” – that is they are within the range of your hypothetical backtested results.

How would you feel if you were down 8% and your backtested results could have you down as much as 15% ? How would you FEEL if this was the case and you were within what you predicted and what you showed your clients?

The answer to this question is very important to know. If you abandon your model because you hate how you FEEL and you do everything you can to rid yourself of these FEELINGS, you will soon be going back to doing what you did before you began your trading career.

On the other hand, if you FEEL bad from this, you can go back to your model and further adjust it to have lower risk and exposure until you FEEL HAPPY with the results.

Take the quiz – it’s for fun. Email me your results and maybe I can point you in the right direction. HAPPY trading!