Part of the appeal of trading options and futures is the ability to use leverage for capital efficiency. How do we calculate the amount of leverage we’re taking on? And what can we do to adjust our risk?
Leverage works both ways, and when misunderstood, can lead to significant drawdowns with small changes in the underlying. Portfolio leverage is theof the portfolio (i.e. “true value”) relative to the liquidation value (i.e. how much money is being used). To calculate this we would divide the cumulative notional value of the portfolio by the net liquidation value of the portfolio.
Portfolios with positions that have cumulative notional values greater than the account’s value are leveraged more than 1 to 1.
Leverage in cash-secured accounts, such as an IRA, will not exceed 1 to 1 (as shares cannot be purchased on margin).
In a standard margin account, portfolio leverage can reach 2 to 1 or even 4 to 1 intraday.
Trading futures offers traders to take on leverage in a capital efficient manner. However, if the notional value of the futures contracts is significantly larger than the trading portfolio, traders will see volatile P/L swings on a percentage basis, leaving little room to be wrong.
What can we do to decrease our leverage? We can trade smaller notional amounts through equivalent ETFs. The Cherry Picks Newsletter provides this information, allowing traders to easily reduce leverage.
Tune in to hear Tom and Tony talk about leverage in your portfolio!