Investments in stocks are always bear some risk. Risk of losing part of your capital. This risk exists especially when we talk derivatives with leverage. Nowadays day-trading became popular. People with nearly no investment experience, lured by well-made internet adverts jeopardise their savings using futures contracts. Humans are emotional creatures and with enough bravado, greed and ambition to succeed easily turn into addiction.
High tolerance for risk (low risk aversion) stems from lack of knowledge rather than from balanced, informed and analysed decision making process. Sooner or later this will lead to bad results and losses. Greed coupled ith lack of patience makes people pick bad times to gamble. Although the worst is lack of knowledge. Those starting their journey with forex have literally no experience to be able to see and predict rapid price jumps. Best example is CHF which climbed over 40% one day in January only to stabilize and plateau with 15% premium over previous days.
Futures contracts are sold with leverage. Contract with price of 100 thousand USD can be bought with just 10 thousand USD. Ten thousand comes from the speculator and the rest (90 thousand USD) from a loan. Thanks to that young players can increase their profits in very short period of time. They have small hard-earned savings at their disposal and want to get rich quickly. Unfortunately sharp fall of an index and the account is zeroed. It can not only clean the initial capital but also create a debt that will need to be repaid.
1. What leverage and speculation can lead to is pictured by a story of an American. Joe Cambell wanted to short sell shares of KalaBios Pharmaceuticals. Company troubled with insolvency on its horizon. With announcements of selling company’s property and closing business soon the bankruptcy was inevitably looming and in those circumstances choosing to short sell would have been logical decision.
It was Wednesday 18 November. Price of KaloBios shares hovered between 1-2 USD. With no good news for the company Joe bought futures contract for 35 thousand USD counting on further fall of KaloBios stocks. Joe used big leverage as the capital he used was only 50% of the contract’s price.
After Cambell made his deal Martin Shkreli (investor) started to buy stocks of this company to take it over. After getting over 50% he announced that KaloBios agreed with him a plan to solve financial problems of the company.
This news made shares to spike by 700% overnight to 16 USD per share. Joe, who on Wednesday had short sell contract and 18 thousand USD on his broker account, woke up on Thursday and realised he owes 106 thousand USD.
In just few hours from a person having savings he turned into a debtor. Not only he lost all the money he worked so hard for but also he will be working to get more to pay up over 100 thousand of his debt. Leverage kills.
2. Similar history happened to Jim Rogers. Famous investor and globetrotter started his career in finance by analysing companies on stock exchange. He was researching information based on which traders made decision to make their calls on whether to buy or not. Utilising his knowledge and money he wanted to short sell (profit from further fall of share price) two companies, both in bad financial situation. His hope that they will be bankrupt finally materialised but before that happened he lost his money. Before both companies filed for bankruptcy prices climbed significantly and Rogers closed his contract losing a lot of his money. This example shows how irrational can market participants be. Raw analysis not always translates into share price and it is something worth remembering.
3. Last example is about Mr X. Last week he asked me to help him out after event wiping out big share of his money. Mr X lost 80 thousand EUR out of 170 thousand EUR in his brokerage account. Losses amounting to half of his capital are the result of just two contracts (Wheat and Oil) he bet on. How commodities he hoped will increase, took 80k EUR into the drain just by dropping by 10-15%? LEVERAGE!!!
Think about it. Leveraging something to the ratio of 5 guarantees that small move of price in the wrong direction brings immense losses. Now the best. Person with whom I was talking didn’t even know that leverage was used, not mentioning level of contango of neither commodities…
In normal circumstances making up this amount of losses is near impossible. How else can you call 100% profit for few weeks in a row? The only way to achieve it would be to use huge leverage but it is the same leverage that lead to this miserable situation in the first place! You can imagine that client never mentally accepted his grim situation. He still hoped to change his fortune and I am wholeheartedly hoping for the best for him.
Use mistakes of others to learn and be cautious during incoming months. Financial markets are the land of opportunities but those are entailed with huge risk and responsibility. Losses are inevitable but you can secure yourself through diversification of your portfolio and avoiding instruments with big leverage. Leverage is a killer also for experienced traders and the volatility we see today will delete the account of many speculators.
To make this summary less grim I give you video of E-trade baby as it has great point.