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Leverage, position size and borrowing against dividends

Discussion in 'Trading Strategies/Systems' started by Aussiest, Jan 25, 2010.

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  1. Aussiest

    Aussiest

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    This is in the Beginners Forum because i want a simplistic view on this.

    If i have 100k cash and i want to put it into shares, what would be the most sensible % of leverage i should use?

    I was thinking i should base it on how much interest i am willing to pay each week.

    Example: i am willing to pay $100.00 per week, so perhaps should borrow accordingly? This would result in borrowing 72k at an interest rate of 6.49% (repayment varies with rate). I could either add to my existing positions, or open entirely new positions.

    Here's the question: Increasing position size (adding to positions) vs. entirely new positions... Your thoughts? Guess it depends on current share performance vs. whether there are better opportunities in market. Am i starting to think like a real trader?!

    In relation to money management and position size, would i base my risk limit (1.5%) on my own capital + the leveraged 72k, resulting in 1.5% risk of 172k, or would i base it on my own 100k capital only?

    I've also thought is that i can use my dividend cashflow to borrow against.

    Example: i am expecting 5k in dividends (pls note, this would require shares > value of 100k, 5k for hypothetical only) (based on rough estimates of previous years earnings, plus discount due to GFC) for the first half year, if the market crashed, i could technically borrow that 72K (as leverage) and buy more shares.

    These are just thoughts, the sums are purely hypothetical (except the bit about max. weekly $100.00 interest repayments).

    I'm just really interested to know what the conventions are (if any) with leverage and borrowing against dividends.

    Your thoughts on leverage, position size using leverage and using dividends to borrow against?

    All comments appreciated :)
     
  2. Aussiest

    Aussiest

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    Actually, this probably belongs in the "Trading Strategies / Systems" forum.

    Mods, if you notice this, can you please move it?

    Thanks

    ;)

    Aussiest
     
  3. JimBob

    JimBob

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    Im not sure about your other questions but your risk limit should, IMO, be based on your own cash, 100k and not your total leveraged amount. If you lose $72k, you arent left with $100k, you are only left with $28k of your own money. The leverage allows you to take the positions with less outlay of your own money, allowing extra positions to be taken.
     
  4. howardbandy

    howardbandy

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    Hi Aussiest --

    There are two components to risk analysis. One is the percentage of your trading account you are willing to risk on any single trade. The other is the percentage that will be lost if a trade goes bad. For most accounts and trading systems, the amount lost by a losing trade is greater than the amount being willingly risked. Whenever that is the case, you cannot buy all the shares you can afford, so leverage is not an issue.

    An example.

    I have a trading account with several "tracks" in it. Each track has a balance of $100,000. I am trading several system-equity combinations and I am willing to risk 2% of the $100,000 on any single trade. I have enough signals that there is always a candidate to buy for each track. For example, I will trade mining stocks in one track, banks in one track, computer manufacturers in one track, etc. That is -- one track trades one issue at a time, and there is always something to buy.

    Assume that my trades have a maximum loss of 8% when they go bad. (A trade with an entry at $20.00 is stopped out if the price falls to $18.40 for a loss of $1.60 or 8%)

    When I get a signal to take a new long position in a stock that is at $20:
    I compute the amount of my trading account I am willing to risk on a single trade -- multiple $100,000 by 2% and get an answer of $2000. I compute how many shares I can afford to buy -- divide $100,000 by $20 and get 5000 shares.

    If I take a position of 5000 shares and the trade goes bad, I lose $8000. $8000 is four times the amount I was willing to risk in my trading account. 8% loss on an individual bad trade is four times the 2% account risk I am willing to take.

    So I have a choice -- buy all that I can afford and risk 8% of my trading account or buy only 25% of what I can afford, leaving the remainder safely in no-risk funds.

    To summarize -- when I get a buy signal, I can buy the number of shares that I can buy with the amount of equity in my trading account divided by the ratio of the trade risk to the account risk.

    If the trade risk is less than the account risk, then I can safely use leverage, otherwise I must leave some funds uninvested and unexposed.

    Do not count on portfolio diversity for a cushion. In a crisis, the correlation of all trades (that are not explicitly inverses) tends toward 1.00 and they all fall together. People sell what they can sell, not necessarily what they want to sell.

    Thanks for listening,
    Howard
     
  5. Aussiest

    Aussiest

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    Hi Howard,

    Thanks for your response. At first i wasn't sure what you were talking about, but now i get from your post that it's about setting an arbitrary amount that you are willing to lose (1.5 - 2%) and stick to that. If the position size requires leverage, then use it, if not, then don't.

    - Why do people use it though? Maybe it alllows them to set wider stop-losses? Perhaps it is good to use once a position runs in your favour in order to pyramid? (i'm getting ideas just thinking about it) - might add to trading plan once thought about more.

    Your idea of "tracks" is a good one. I've been deciding how to allocate my capital. Other strategies might include:

    1. x% long term, y% swing (%'s are adjustable)

    2. x% long term + x% swing + x% leveraged (if market drops - high risk strategy though)

    3. Spec account

    4. % allocated to own strategy + % allocated for subscription service

    The list goes on. As i've become more accustomed to trading, i've realised that you can run several strategies at once (okay, it took me a while). I've also thought about using a different broker for longer term shares as the temptation to liquidate on a shorter term basis is high using one single broker.

    What JimBob said is right (thanks JimBob :)), maybe it's a bad idea to include leverage in your risk amount. I agree with this to a certain extent.

    However, if one was to include leverage in their risk factor, positions and therefore gains could be increased accordingly.

    Btw, i agree with you about 'diversification'. I tried this very early on in my trading career and realised it just didn't pay off. CSL showed me this (a traditional 'defensive' stock), it's such a creeper. Capital is better allocated elsewhere...
     
  6. howardbandy

    howardbandy

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    Hi Aussiest --

    You wrote: "However, if one was to include leverage in their risk factor, positions and therefore gains could be increased accordingly."

    Ralph Vince has written several excellent books discussing the effect of position size and leverage in trading. His latest book is "The Leverage Space Trading Model", and it is well worth reading. He points out convincingly that every trading system uses leverage, even if they are trading long-only equities in a cash account and do not use margin.

    All trading systems that have unlimited risk will eventually go bankrupt.

    Most vehicles traded, including equity shares, futures, credit option positions, currencies, CFDs, ETFs, and mutual funds, have unlimited risk. The question is whether "eventually" occurs before of after you stop trading that system.

    Thanks for listening,
    Howard
     
  7. skc

    skc Goldmember

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    Aussiest, you should position size based on unleveraged capital. It is incorrect to size position based on leveraged capital. The whole reason of position sizing is to control how much you lose as a percent of your capital - your own money. Leveraged money is not your money.

    Even if you size your positions based on unleveraged capital, sometimes you will end up using some leverage. For instance, if you are risking 2% of your capital (e.g. $2K) and the stop distance is 10c, your position size would be $20K. If you happen to find more than 5 of such opportunities, you will have to use leverage. But note Howard's comment regarding correlation...

    Howard. Sorry don't have the book you mentioned. But for the life of me cannot think of an example where using cash to hold long direct equity can be considered as using leverage. You simply cannot lose more than you put in right?
     
  8. Trembling Hand

    Trembling Hand Can be found on the bid

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    And the same with option purchases?

    Even with something like futures if taking a long position you don't have unlimited risk. The assumption that just because you have to put up only 10% of the contract value to your broker means you are trading leveraged is wrong.

    Then many miss out on some great trading opportunities, oil for example, because they don't want to use risky derivative but then go and chase 2 bob mining companies. :banghead:

    Howard can you clarify what you are saying about unlimited risk?
     
  9. Aussiest

    Aussiest

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    The penny has dropped on the whole leverage thing. I get it now, thanks SKC.

    Some more thoughts on risk and position sizing:

    1. In times like these (market uncertain, nearing a major support line - 4600), could halve risk limit, eg, risk 1% now, just incase get stopped out, and re-enter if ORDS breaches 4600, risking the other 1% later.

    Could also use this strategy if market is bullish to pyramid during a pull back. Eg, wouldn't have been a bad idea a few months ago.

    2. TAKE OPENING GAPS INTO ACCOUNT when setting your stop loss. Eg, i paper traded RIO today: opening price (long) $70.15 ... Stop loss @ 69.80 ... risking 1.5% of 100k (hypothetical amount) > position size = 2857 (way too large for me).

    If this position gaped down on the open next day, i would stand losing a lot more than 1.5% of my trading account.

    Revised it down to include possibility of gap. RIO can sometimes gap down by $2+.

    So, new stop loss = 67.80
    New position size = 1500/2.35 = 638.

    *Major point: take opening gaps into account when you set your stop loss!

    That is all
     
  10. skc

    skc Goldmember

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    IMO that RIO position is still too large. 638 x 70.15 = $45K or 45% of your capital. Personally, I think 25-30% sounds about right. This also helps you open multiple directions without too much leverage.

    There are benefits in diversification... not from uncorrelated returns, but from reduction in single name risk.
     
  11. Aussiest

    Aussiest

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    Yes, 3 positions sounds better.

    I also get what you mean about spreading the risk around.
     
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