Lessons for Using Leverage

Leverage is something that forex traders are intimately familiar with – and most use – but leverage has significant risks associated with it. Even the biggest traders occasionally fall foul of using too much leverage – the well-publicized failure of a few hedge funds is a perfect illustration of this.

In fact, individual investors can benefit from studying these failures, since exactly the same factors that cause major hedge funds to fail also apply to retail investors.

How do hedge funds use leverage?

By definition, the only way that hedge funds can generate the high returns that their clients demand is to use leverage. One example of this is a currency carry trade. This is where a fund borrows money in one currency at a low interest rate, and then uses the money to buy another currency that has a higher interest rate. The return that they can make is essentially the difference between the two interest rates minus the cost of borrowing the money. Even when the spread between the two interest rates is relatively high, the return without leverage is rarely more than 3% to 4%.

However, by using leverage, hedge funds easily double this return. However, no matter how good these trades look in principle, the sad fact is that they can and do go wrong. When this happens, the hedge fund can run into significant problems unless they have a proper risk management strategy in place. There are many different ways of managing risk, ranging from very simple to extremely complicated, but all of these strategies are designed to limit losses if the market behaves in a completely unexpected way.

What lessons can individual investors learn?

First of all, successful hedge funds know how to structure their positions so that they survive when the market exhibits unprecedented behavior. This is particularly important when it comes to margin calls – which are an unavoidable consequence of using leverage. A large number of hedge fund failures come about because they can’t meet these margin calls, resulting in them having to exit positions at the worst possible time.

The second lesson is a direct consequence of the first one – always make sure you have enough reserves on hand to rescue any leveraged position. What this means is that it is fine to have part of your portfolio in highly leveraged positions, but make sure that your entire portfolio isn’t tied up in these – particularly if they are poorly diversified.

Finally, don’t get greedy. If you try to increase your takings too much through leverage, you will end up in serious trouble. Plan for all contingencies – including ones that you can’t predict – and make sure that your trades are set up so that you can survive the worst scenario. This may reduce your potential profits, but it will also ensure that you aren’t wiped out when things go wrong.