Apart from the D-word, the Street’s got the L-word too.
This L stands for L-E-V-E-R-A-G-E.
So, how much leverage do you enjoy from your spouse?
Or, do you have any leverage on politician so-and-so?
Or, bank so-and-so or brokerage so-and-so is offering a 10:1 or a 16:1 leverage on derivatives.
Just racking up the various uses of the L-word.
In colloquial terms, the amount of leeway your spouse allows you in your marriage is called leverage. Also, the amount of dirt you have on a politician to coerce him into following your wishes – that’s called leverage too. But for now, let’s get back to the Street.
On the Street, The L-word gives the D-word its power to destroy big.
Do you remember what the D-word was? D-E-R-I-V-A-T-I-V-E-S.
A derivative is a stink normal trade without the power of leverage. When brokerages start offering you leverage like 16:1, the stink normal derivative becomes lethal. Then, small amounts of volatility can wipe out the principal put up by you. If a down-turn continues, your loss can become many times your principal. People can go bankrupt like this.
You see, for every market move, your profit or loss is the move times the leverage. On a 5% move, a 16:1 leverage can result in 80% profit or loss. Leverage works on the upside as well as the downside.
The problem arises when the player doesn’t know how to play either side. Most players don’t know.
Leverage can be used to one’s advantage only when the down-side is protected with a stop. Most people don’t use a stop while deploying leverage. That’s why they lose, and lose big.
This singular characteristic of the average market player of not knowing how to use stops results in a spiralling bomb during market down-turns. As losses pile up, selling pressure increases due to dejection or the like as the market heads even lower. What if they’d taken a 2% or a 5% or even an 8% hit when a stop was hit? They’d be out and the market could stabilize near the stop level because of lack of further selling pressure.
Leverage is something that must not be used if one doesn’t fully understand how to use it. Unfortunately, almost everyone consumes leverage as if it were a bar of Snickers. Leverage is served to customers on a platter. Even a loan, or debt on the credit card is leverage.
Leverage is the driving force of consumerism and the modern industrialized world.