A Primer on Leverage

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What is Leverage ?
In simple words Leverage trading is
trading using borrowed money

Why do we need to borrow ?

We don’t have to.. but if your strategy can
generate positive returns with manageable
risk, you can improve your absolute
returns.

Lets see an example..

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Say we have 7.5 lacs capital

If there was no leverage how many lots of Nifty would be able to buy?

Nifty say at 10000, lot size 75 , so 1 lot is worth 7,50,000

So we will be able to buy 1 lot.

Now lets the exchange offers you a leverage of say 10x (hypothetical)

What that means is that you are putting up only 7.5L and you are
borrowing 67.5L as debt from the exchange to buy 75 Lacs worth of
nifty or 10 lots.
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Now say if Nifty moved up 10% from 10000 to 11000

In first case you had 1 lot and you would make a gain of 75*1000 =
75000 on investment of 7.5 lacs, a 10% gain

In second case with the leverage the gain would be 75*10*1000=

750000 on investment of 7.5 lacs, a 100% gain

All sounds great. So what is the catch

The catch is that if Nifty moved 10000 to 9000,

Case 1 you would have lost 10% of your capital
Case 2 you would lost 100% of your capital!!

So LEVERAGE IS A DOUBLE EDGED SWORD TO BE USED VERY

VERY CAREFULLY

JUST BECAUSE IT IS AVAILABLE, WE SHOULD NOT JUMP and USE IT

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Capital Preservation is a key part of any good strategy hence Leverage

has to be used CAREFULLY

Leverage has to be used more when we are more sure that it will work
for us.

When we are less sure of the outcomes or when we are having a

streak of losses we should reduce leverage to build our confidence
back.

When the markets become very volatile, that is also a time to reduce
leverage

Leverage should be minimal when starting out and then as your capital
grows you can try to very gradually add some leverage.
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What is the usual leverage allowed by the Exchanges – It is usually

around 7 to 8 times.

When you hear that margin on a nifty lot is 1 lac it basically means
that if you put up 1 lac capital, the exchange is allowing you to take a
position worth 7.5 lacs ( at Nifty 10000) or a lev of 7.5X

BUT AS CONSERVATIVE USERS you should not go beyond 3x.

Why ? A 33% drop in notional price will wipe out your capital at 3X
also.

A overnight 10% drop in Nifty from 10000 to 9000 if you were long
Nifty will make you lose 30% of your capital

So a conservative approach will ensure EVEN if such an event happens

you should be left with sufficient capital to try build back your account.
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Now in case of STAIRS Lets say you are starting with 10 lacs capital
and you divide it 5 lacs each in NF and BN

So at 3X you can take notional position of 15 Lac Nifty and 15 lac BN

That translates into

for Nifty at 10000 : 1500000/10000 = 150 = 2 lots of 75 each

for Bnifty at 20000 : 1500000/20000 = 75~ 4 lot of 20 each

Now as your strategy progresses the capital will keep going up and
down….
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Case 1

Lets say you started with 10L and in 6 months you are at 17 lacs with
NF at 8 lacs and BN at 9 lacs

The same leverage will now give you different position sizing. ( assume
for simplicity NF at 10000 and BN at 20000

so at 3x now you get NF

8*3=24L = 24L/7.5L ~3 lots

And BN
9*3=24L = 24L/4L ~6 lots

So you can see that as your capital grows you are taking higher
positions at the same leverage thus trying to improve your outcome
even more.
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Case 2

Lets say you started with 10L and in 6 months you are at 7.5 lacs with
NF at 3.5 lacs and BN at 4 lacs

The same leverage will now give you different position sizing.
( assume for simplicity NF at 10000 and BN at 20000)

so at 3x now you get NF

3.5L*3=10L = 10L/7.5L ~1 lots

And BN
4L*3=12L = 12L/4L ~3 lots

So you can see that as your capital drops you are taking smaller
positions at the same leverage thus trying to conserve capital till you
can reach a level to take bigger positions.

It is a self adjusting mechanism.

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I hope you would have some better understanding of leverage with

this primer.

Distinguish leverage you want vs leverage that is offered.

The margin the broker charges is inconsequential in our calculation as

we are taking a more conservative view

By taking a conservative view, we will have a lot of idle capital.

Consider that as dry powder for the rainy day.

The STAIRS Sheet also allows you to set up your own leverage and
position size.

Any questions please let me know at alok@weekedinvesting.com