Assessing Risks and Returns from Short Selling and Leverage

Leverage introduces risk to your day trading, and that can give you greatly increased returns. Most day traders use leverage, at least part of the time, in order to make their trading activities pay off in cold, hard cash. The challenge is to use leverage responsibly. The two issues most related to leverage are losing your money and losing your nerve. Understanding those risks can help you determine how much leverage you should take, and how often you can take it.

Losing your money

Losing money is obvious. Leverage magnifies your returns, but it also magnifies your risks. Any borrowings have to be repaid regardless. If you buy or sell a futures or options contract, you are legally obligated to perform, even if you have lost money. That can be really hard. Day trading is risky in large part because of the amount of leverage used. If you don't feel comfortable with that, you may want to use little or no leverage, especially when you are new to day trading or when you are starting to work a new trading strategy.

Losing your nerve

The basic risk and return of your underlying strategy isn't affected by leverage. If you expect that your system will work about 60 percent of the time, then that should hold no matter how much money is at stake or where that money came from. However, it's likely that it does make a difference to you on some subconscious level if you have borrowed the money.

Trading is very much a game of nerves. If you hesitate to make a trade, cut a loss, or otherwise follow your strategy, you're going to run into trouble.

Say you're trading futures and decide to accept three downticks before selling, and that you will look for five upticks before selling. This means you are willing to accept some loss, cut it if it gets out of hand, and then be disciplined about taking gains when you get them. This strategy keeps a lid on your losses while forcing some discipline on your gains.

Now, suppose you are dealing with lots and lots of leverage. Suddenly, those downticks become too real to you — it's money you don't have. Next thing you know, you only accept two downticks before closing out. But this keeps you from getting winners. Then you decide to ride with your winners, and suddenly you aren't taking profits fast enough, and your positions move against you. Your fear of loss is making you sloppy. That's why many traders find it better to borrow less money and stick to their system rather than borrow the maximum allowed and let that knowledge cloud their judgment.

Lenders can lose their nerve, too. Your brokerage firm might close your account because of losses, even though waiting just a little longer might turn a losing position into a profit.

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