Tuesday, January 20, 2015
Most speculators are morons.
After spending more than three decades in the financial business, and after watching so many folks wipe out their portfolios, there really is no other way to say it.
I'm talking about folks who borrow large amounts of money to buy stocks, bonds, currencies, commodities, or anything else.
The thinking goes something like this... If you can borrow money at 3%, invest it, and make 10%, 15%, or even 20%, then you should borrow as much as possible and reap the returns.
It makes perfect sense if the outcome is guaranteed. But it's never guaranteed. That's a fact that gets overlooked by the majority of speculators. And that's what leads to their downfall...
For an example of why leverage is so dangerous, let's look at what happened to currency speculators who bet in favor of the euro and against the Swiss franc last week.
Prior to last week, the franc was trading at a 4% premium to where the Swiss National Bank (SNB) had agreed to "peg" it to the euro.
As long as the peg (the fixed exchange rate) remained in place – which the SNB publicly stated it would – then, over time, the franc would have to fall in value against the euro. Speculators making that bet could earn 4% as the franc fell in line with its peg.
But a 4% gain isn't that exciting. So speculators leveraged their bets. They borrowed money at 3% interest and used it to generate a potential 4% return. By using a 2:1 leverage ratio and doubling his exposure, a speculator could increase his return to 5%. A 10:1 leverage ratio would boost his annual return to 14%.
That's a terrific return for a seemingly guaranteed trade. But it still wasn't enough for some speculators.
Many currency speculators leveraged their bets from 50 to 100 times their original investments. They were positioned to make between 54% and 104% on what they viewed as a risk-free, guaranteed trade.
But that all changed last week. On Thursday, the SNB got rid of the peg. It let the financial markets decide what the franc was worth relative to the euro. The franc jumped nearly 20% in one day. And a lot of currency speculators got wiped out.
For an unleveraged trader, a 20% move in the wrong direction hurts, but it doesn't take you out of the game. You can exit the position, take your loss, and still be alive to trade the next day.
But if you're leveraged 10:1, 50:1, or 100:1, you're wiped out. There is no way to recover. Your account is gone. And chances are good you'll leave your brokerage firm on the hook for the balance of the loss.
Take a look at this chart of Forex Capital Markets (FXCM), one of the leading currency-trading brokerage firms...
FXCM dropped 25% on Thursday. It did not open for trading on Friday. But the stock traded for about $1.20 per share in pre-market trading.
It also announced that the negative equity in customer accounts – the amount that debt obligations exceeded equity – was greater than the net capital of the entire firm.
In other words, the company was basically bankrupted by the leveraged bets of currency speculators. Speculators lost 100% of their money. And they wiped out their brokerage firm as well.
A lot of stock market speculators think this can't happen to them. Their brokerage firms limit their bets to 4:1 leverage at most. But even with that limited amount of leverage, a modest downside move can wipe out your account.
What if you had used leverage to buy shares of Transocean (RIG) – one of Wall Street's favorite oil-services firms – back in August at about $40 per share? If you bought 100 shares with your own money and then borrowed money to buy another 100 shares, your entire position would be wiped out now with the stock trading well below $20.
In short, leverage kills.
No matter how strong the argument might be, borrowing money to invest in anything is usually a bad idea. It might work to your benefit at first. But ultimately, it tends to lead to disaster.
It's especially important to keep this in mind right now...
As of November 30, the total margin debt on the New York Stock Exchange (NYSE) was just over $457 billion. Investors are continuing to borrow record amounts of money to throw into stocks as the market is close to an all-time high.
Right now, the total margin debt on the NYSE is 20% higher than where it peaked in July 2007 – just a couple of months prior to the stock market high back then.
Traders who were leveraged to the hilt back then didn't survive the downturn. And they didn't have any cash left to invest when stocks hit bottom in March 2009.
If you've been riding the stock market higher and you've been using leverage to enhance your returns, right now is the time to reduce your exposure. Lighten up your positions. Reduce your leverage. Give yourself a chance to buy stocks at cheaper prices when the inevitable decline occurs.
In short... don't be a moron.
Best regards and good trading,
"Leverage is financial crack," Jeff writes. "The first hit feels good. It's a trader's high... We want more of it. So we use it again, and again, and again – until we're addicted." Eventually, though, "it kills us." Learn more here: Wall Street's Favorite Drug Will Kill the Stock Market.
To see just how leverage kills, take a look at the story of Robert Citron... "Citron was so successful," Jeff says, "neighboring municipalities entrusted him with their funds in the hopes of receiving equally high returns. And they did... for a while." Learn why leverage is "what every investor should worry about today."