Transcription
All right, hello and welcome to Camel Finance. I'm your boy Camel, and today I'm going to be talking about leverage.
I'm going to add this video into the trading tutorials playlist. If you haven't seen at least the video on risk management from that playlist, then it's highly advised to go and watch that first. That way, it will make this video a lot easier to understand, and it will also make you a better trader. Okay, that risk management video is the key to being profitable, so if you haven't seen that, go and watch that.
This video is going to be about leverage. So, first of all, I want to define leverage just so that we're clear on this. So, I've just got an Investopedia definition here: "What is financial leverage? Financial leverage is the concept of using borrowed capital as a funding source. Leverage is often used when businesses invest in themselves for expansion, acquisitions, or other growth methods. Leverage is also an investment strategy that uses borrowed money, specifically the use of various financial instruments or borrowed capital to increase the potential returns of an investment."
So, the key takeaways here is that leverage is using debt, borrowed funds, to amplify returns from an investment or project. Companies can use leverage to invest in growth strategies. Some investors use leverage to multiply their buying power in the market, and that is the type of leverage that we are going to be talking about today.
So, some very, very common questions I get are: How much leverage should you use? Right? How much leverage is too much leverage? And what do I personally use? What do I personally recommend in terms of leverage? Now, I want to start by keeping it real, as always, okay? If you have to ask, then you're not qualified to use leverage, okay? But perhaps after this video and that risk management one I just talked about, then you will be.
So, how much leverage should you use? Like I said, if you have to ask, the answer is zero. Most people should not be using leverage. How much leverage is too much? Is a completely wrong question to ask, okay? And I'm going to prove to you why this is the wrong question to ask in a minute. This question actually makes absolutely no sense, and I personally would not recommend anyone actually use leverage. However, like I said, at the end of this video, you are going to be able to understand leverage a whole lot better.
So, as always with me, everything's really super simple, okay? There's nothing complicated going on here. Get this basic piece of knowledge down, and you will completely understand leverage. So, it really is this simple: As with any trading account, manage the risk first. This should be the first thing that you figure out when you're going to take a trade. Is where has your stop loss got to go? And can you afford to set that stop loss at that place, knowing that the risk is correctly managed? Once you have set your stop loss in the correct place, okay, the leverage is a byproduct. The leverage should be scaled up or down depending on where your stop has to go and the size of your account. Again, we're going to go over this in more detail in just a second.
So, I'm going to pull up a chart of the Triple Qs, okay? I'm going to show you exactly what I mean, and then I'm going to show you some extreme examples, okay? I'm going to demonstrate some extreme examples for you, such as how using just 2x leverage can be degenerate, and I'm also going to show you how I could use 120x leverage and it would still be considered a very, very safe trade, okay? So, hopefully, by now, you're starting to see that when we go back here and say, "How much leverage is too much?" Like I said, this is the wrong question to ask. Leverage should be a byproduct after you've managed the risk on your trade. And like I said, we're going to show you a couple of examples where 2x leverage could be degenerate and 120x could be incredibly safe.
So, I've got the Triple Qs here. I'm going to use this as an example. I'm going to grab my replay tool and I'm going to cut in to about here. Now that we've gone back in time, I'm going to grab a trend line tool, draw a trend line across the top, and I'm going to say, "Let's assume that my thesis for the trade is that this is going to break out." When it does, I want to be long here, and upon getting a breakout, I want to add a long position, something like this. So, of course, the first thing we need to do is wait for this thing to set up. So, I'm going to hit play, wait until we get a buy signal triggered, and there it is, right? We've got a breakout above the trend line on a daily closing basis. Let me zoom in so we can see this.
So, let's assume this is my thesis for the trade, okay? We are getting ready to go long. We see the breakout on the daily closing candle. We decide we're going to add a trade here, okay? Now, here's how I would do it. Here's the correct way to do it. If, first thing, I need to do is figure out where my stop loss is going to go, okay? Can I have a stop loss in here? Maybe? Would I want it at least here? Perhaps even down below the lows at the bottom? Yes, this would be a nice wide stop. This would give me plenty of room if my thesis is indeed that this is going to be the bottom and we're going to get a nice long breakout. And so, assuming I can size this position so that if I'm wrong, I'm not taking any more than 2% out of my total account, then we can accept this trade. We can place this trade and we can keep the stop loss in this neighborhood here.
Now, if I want to do this on leverage, here's how this would work. I can add as much leverage as I want on this trade, so long as if I'm stopped out, okay, if the market trades into my stop and the position is taken out, I do not lose more than 1 to 2% of my total account size. So, when I was saying earlier on that you could see that leverage is a byproduct, okay? I'm not thinking about how much leverage to put on here. You'll notice that I think about: Where's the stop got to go? Where's a reasonable place, either here or here, okay? Somewhere in this neighborhood. Once I've decided where my stop has to go, I can now look at my account size, see how much I would be taken out here, see if that equates to 2% or less than my total account size, and if it does, then I can place this trade.
Now, if that is 2%, then I can't afford any leverage on this, okay? If that's 2% of my account, if my account is £1,000 and this is going to cost me £20 if I'm stopped out, then I'm already at 2% risk, so I can't afford to put any leverage on here. But if I had a million-pound account and this was only going to cost £20 if I was stopped out, then I can afford to lever this up multiple times until the total stop loss is going to cost me 2% of my account. If I only needed my stop in this neighborhood, if I felt like this was a good place to put the stop and I wasn't going to get taken out of the trade here, then because I've got a smaller stop, I can afford to add more leverage. And if I felt like, no, actually, this is a pretty volatile market, I want this stop low all the way down here, I want to make sure I give myself the best chance and the most room to stay in the trade, well, now I've got a wider stop, so therefore I must be using less leverage.
So, hopefully, you can see here, leverage comes last, and as I said, is a byproduct, right? The first thing I want to do is find a buy signal, figure out where the stop's going to go, and then ask myself, "If I'm wrong, will it take out more than 2% of my account?" If the answer is yes, then I can't afford this trade. If the answer is no, then the question is, "Can I afford to lever it up and still keep the stop loss contained below 2%?" If I put 2x leverage on and this stop is going to cost me 1.9% of my account, then I can afford 2x leverage. If I put 120x leverage on and I'm taking out, and it's only going to cost me 1% of my total account size, then I can easily afford this trade.
So, you can see it's not the amount of leverage that I put on. It is the amount it's going to cost me if I'm wrong. So, again, let's say I want to have a nice wide stop, and all of this on 3x leverage equates to 2% of my account, then I can say, "Happy days. Let's see what the market will give." Right? And off it goes, and you can see as it progresses, this would have been an absolutely fine trade. In fact, this is one we took live on the channel at the time, in real time.
Going back to this idea of the extreme examples, okay? How can 2x leverage be considered degenerate? Well, if I have a £1,000 account size and I put a 2x leverage trade on, and if my stop loss is triggered, it's going to cost me £500, 50% of my account. That's degenerate. And at the other extreme end of this spectrum, I could apply 120x leverage to a trade, and it could be considered very safe, okay? If I take an entry here, my stop loss is down here in a reasonable place, and my profit target is all the way up here, and with 120x leverage, this stop will cost me only £150, and I've got a £5 million account size, then I can easily afford to take that small loss. That loss is easily contained below the 2% threshold, and even with 120x leverage, if I'm wrong, if I'm stopped out, I'm not even going to notice it missing from my account.
So, I hope you can see that it is not the amount of leverage, right? 2x can be degenerate, 120x can be safe. It's not the amount of leverage that's important. It is, as always, the amount you stand to lose if you are wrong. Keep that number contained to 2%, and everything will be just fine.
So, to summarize, here is how to correctly use leverage, okay? Figure out where your stop loss needs to go first. Find a trade, identify where the stop loss needs to go, make sure it's reasonable, okay? It's no good if the average daily swing of the asset is 7%. It is no good having a stop placed half a percent below your entry, right? If the average true range of an asset is oscillating by 7% and you come in and set a half a percent stop loss, you're going to get taken out. So, figure out where your stop loss needs to go to keep you in the trade. Find a set of local lows that is reasonable to use, put the stop just below those lows, and that way you'll be able to stay in the trade.
So, step one: Figure out where your stop loss needs to go. Step two: Figure out how much it's going to cost you if you're wrong, okay? It should be, like I said, no more than 2% of your total account size. If it is 2% of your account that it's going to cost you to get stopped out, then you cannot afford any leverage at all. If it's significantly less than 2% of your total account size, you can afford to apply more leverage, which leads me into point number three.
The final step in how to correctly apply leverage: You apply the leverage up or down depending on your account size, okay? So, again, figure out where the stop needs to go, figure out how much you're going to lose if you're wrong, ask yourself, "Is it contained to 2%?" And if it's significantly below 2%, then you can start to add leverage to ensure you maximize your gains without violating that 2% account risk rule.
So, it really is that simple. As with anything, understanding the simple stuff, doing the basics correctly, is what's going to make all the difference. I'm your boy Camel. Until next time, take care for me. All the best. Cheers. Bye.