11

DEC
2018

Leverage: Can you really have too much of good thing?

This blog was published on 11/12/2018 and does not constitute  advice, nor should it be seen as a personal recommendation from Societe Generale.  Information quoted within may be out of date at the time of your reading this blog.

 

With Christmas looming, the fond memories of my grandmother’s mince pie recipe come flooding back, as do her wise words of advice to an excited five year old boy. With evidence of what was my sixth mince pie in as many minutes scattered around my mouth, and a look of queasiness abound, she sat me on her knee and explained that you really can have too much of a good thing.

 

We have all no doubt learnt this lesson at some point in our lives, but sometimes it’s still hard to fight the urge, and at times we need a little help, whether in the case of too many mince pies, it being my grandmother, or in the case of investments with too much leverage, the regulator.

 

I of course refer to the limits imposed by European regulators in March 2018, on the amount of leverage retail investors can take out using CFDs and spread bets...and the worries of the FCA, whom in their review of CFDs and leverage had “particular concern given the risk of rapid, large and unexpected losses ” for retail clients.

 

But have they gone far enough: how much leverage should a sophisticated investor really be using in their trading activities, and for those who may have learnt their lesson the hard way, what alternatives are available?

 

According to an FCA Consultation Paper in December 2016 over 80% of clients lost money on CFD products over a year, with some leverage being available in excess of 400 times. In this context, the leverage limits set by European regulators could well seem more than enough to help protect investors:

  • 30:1 for major currency pairs;
  • 20:1 for non-major currency pairs, gold and major indices;
  • 10:1 for commodities other than gold and non-major equity indices;
  • 5:1 for individual equities and other reference values;
  • 2:1 for cryptocurrencies;
 
But even at these levels of leverage, there remains a high level of risk to investors and the potential to lose more than you invest, something that we should not forget.


An article in ‘The Good Broker Guide’ published in October finds that over leverage is one of the biggest mistakes traders make. It reports that “This is an easy mistake to make as when you think you have a good trade idea, you want to try to make as much money as possible. You set your trade to take up as much margin as possible.  The problem with this is that it doesn’t leave much room for error.  In trading, you need breathing space for when a trade does not go your way straight away.  If the trade moves against you and you can’t afford to run a small loss to start with you will be on margin call and the broker will close your position because you can’t afford it.” 

The benefits of CFD trading are clear; they include access to and betting on markets globally, low borrowing costs, low margin requirements, no shorting or day trading rules, and the ability to significantly leverage a trade. But also, here is the catch... excessive leverage is one of the biggest issues with CFD trading, as it also magnifies losses and the requirement for the dreaded margin call.

Margin calls are the reason traders can lose more money than they initially put in. Trading on margin requires the trader to put down cash and securities in a brokerage account, which acts as collateral for the margin loan used to trade CFDs. Once the funds are borrowed to purchase the securities, the broker can then sell off the other assets to satisfy the margin loan. A margin call happens when the asset relative to the debt in the account falls below a certain level. 

When there is a margin call, the broker can demand payment back at any point and doesn’t have to notify the trader. If the account doesn’t have enough cash to pay the margin loan, then the trader is legally bound to pay the debt. 

Historical analysis performed by Societe Generale’s engineering team over the last 10 years (2,824 observations) shows that even with the new limits on leverage, investors could still sustain a 100% loss of thier investment and facing margin calls more often than they realise. 

 


*Long and short positions combined
Source: Societe Generale, data from 01/01/2008 to 29/10/2018. THE FIGURES RELATING TO PAST PERFORMANCES AND/OR SIMULATED PAST PERFORMANCES REFER OR RELATE TO PAST PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS. 

 

Take for example the equity indices, like the FTSE 100, where CFD investors can take up to 20 times leverage. If the FTSE 100 Index moves by more than 5%, you can lose 100% of your investment and face margin calls.  

Over the last 10 years, if you were to hold a long FTSE 100 CFD for a week with 20x leverage, you would have lost 100% of your money in about 6% of the time. Conversely if you were to hold a short FTSE 100 CFD with the same amount of leverage, you would have lost 100% of your money in about 5% of the time.

Our analysis shows that these statistics are similar for other European equity markets. For example, in the case of the EuroStoxx 50 Index, investors would have lost 100% of their money in 10% of the time when holding a long position for a week and 7.5% of the time when holding a short position for a week.

Commodities are even more volatile, therefore leverage limits are set to only 10 times i.e. a change on the underlying of 10% would see you lose 100% of your investment and face margin calls (bar gold that is set at 20 times). 

Even so, over the same 10-year period, if you were to hold a long Oil CFD for a week with 10x leverage, you would have lost 100% of your money in about 6% of the time. Conversely if you were to hold a short Oil CFD with the same amount of leverage, you would have lost 100% of your money in about 5.5% of the time.

 

Despite this, can leverage be viewed as anything other than a dangerous speculative trade? 

 

Don’t get me wrong, just as mince pies are tasty, leverage can be an excellent tool allowing investors to speculate on the price of financial markets rising or falling. Therefore, making their money work harder for them, with the opportunity to make far greater gains than on more traditional shares or funds. 

However, there are alternatives to CFDs/Spread Bets that offer more modest levels of leverage, which still offer the opportunity of high potential returns over short periods of time, but perhaps with less of the risk.

Take for example Leveraged Exchange Traded Products. These products, listed on the London Stock Exchange and traded daily via your stockbroker, offer more modest levels of leverage of 2x, 3x or 5x, and cover a wide range of underlyings such as equity indices, commodities and currency pairs. 

They can just as well act as an important tool for investors wanting access to certain strategies such as tactical trading or short-term hedging positions.

Importantly, you can never lose more than you invest, no matter what happens to the underlying you are tracking.

Such leverage offers a very different type of journey for an investor, and arguably one that allows you to sleep a little easier at night in the knowledge that the likelihood of losing your investment entirely is greatly reduced.

Applying a maximum leverage of 5 times for example, historical analysis (2,824 observations) shows a very different picture with greatly reduced occurrences where investors lost all their money.

 

*Long and short positions combined
Source: Societe Generale, data from 01/01/2008 to 29/10/2018. THE FIGURES RELATING TO PAST PERFORMANCES AND/OR SIMULATED PAST PERFORMANCES REFER OR RELATE TO PAST PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS. 

 

Importantly, this reduced risk of full capital loss still offered opportunities for significant returns for those who predicted the market correctly. 

For example, if one looks at the average 5th percentile and 10th percentile of returns (for short products), or 95% and 90% percentile (for long products), over just a single day, these underlyings have demonstrated the type of volatility that, especially when multiplied by 5 times leverage for example, can deliver returns well in excess of 10% in a day, arguably more than enough for even the hungriest of investors.

Source: Societe Generale, data from 01/01/2008 to 29/10/2018. THE FIGURES RELATING TO PAST PERFORMANCES AND/OR SIMULATED PAST PERFORMANCES REFER OR RELATE TO PAST PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS

 

So, next time you review your trading portfolio and strategies, and reach for your next mince pie, spare a thought for Leveraged Exchange Traded Products and how they can help you achieve your goals. To view the full range of Societe Generale Leveraged ETP’s, you can click here
 
Remember, as with most investments, the value can go down as well as up, and as a leveraged investment these products are designed for sophisticated investors, so if in doubt, seek advice.

 

Post by: Zak de Mariveles, Head of UK Exchange Traded Products


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Risk Warning: Short & Long Leveraged ETPs are suitable for sophisticated retail investors. Both gains and losses will be accelerated in comparison to a direct investment in the underlying asset.
 
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