This blog is all about how to multiply your gold over time instead of just buying and holding it. So I want to write today about one of the most effective tools that can be used to do that: leverage.
Many beginning gold traders fear leverage because they think that it’s too risky. And it’s true that it does increase your risk, but there are also strategies one can use to limit this risk while still gaining the greater rewards that come with leveraged trades.
So how can you use leverage to your advantage instead of allowing it to use you?
First, let’s begin with an understanding of what leverage is.
Gold Trading Without Leverage.
In a normal gold trading transaction, you do one of two things: either you spend U.S. dollars to buy gold now because you fear that gold will be more expensive in the future or you sell gold to obtain U.S. dollars now in the hopes that you can buy the gold back at a cheaper price later.
As an example, let’s suppose that you believe the dollar will go up in its gold value next week (in other words, it will be possible next week to buy more gold with the same amount of dollars).
So you sell 100 grams of gold. Right now, 100 grams of gold will allow you to obtain $4,061 (the current spot price of $40.61/gram X 100 grams).
Next week, you look at the gold price and find out that it has fallen to $39.61, a dollar cheaper than it was when you sold it. That’s an increase in the value of the dollar of over 2.46%. Not bad for just one week.
Now you’re afraid that the upswing in the dollar may have spent itself, so you go ahead and buy back your gold at the lower price. Your profit in dollar terms is $1 X 100 grams = $100. At the new, lower price of gold, this allows you to buy an extra 2.52 grams. So you started off with only 100 grams but now have 102.52. This isn’t much profit for all the trouble you went through to make the trade.
This is why trading gold without leverage should be reserved only for trades that you’re going to hold onto for at least a few months. Otherwise, the small fluctuations in the price of gold just don’t generate enough profits to bother with.
Gold Trading With Leverage.
But what if you could find a way to increase the amount of profits you could make from very small fluctuations in the price of gold?
This is where leverage comes in.
In a leveraged gold transaction, you take a small amount of gold and lay it aside as “margin”. This margin is then used as collateral to borrow many times its own amount in either gold or U.S. dollars. For example, many futures and forex brokers allow margin levels of 1:100 or even 1:200. So one gram of gold could allow you to borrow up to 100 or 200 grams.
To go back to our earlier example, let’s say that you think the gold price of the dollar will go up next week. But instead of selling 100 grams of gold, you lay aside just 5 grams as margin and use 1:200 leverage to borrow 1000 grams, which you sell for $40,610 ($40.61 X 1000 grams ).
Next week, the price of gold falls to $39.61. So you buy the gold back for $39,610 and pay the 1000 gram loan back to your broker. Your profit is $1 X 1000 grams = $1000, which you can use to buy 25.24 grams of gold for yourself.
So you started off with 100 grams and now you have 125.24. That’s about a 25% increase!
The Risks of Using Leverage.
So what is the downside to leveraged gold trading?
Let’s consider the first example again. But this time, let’s assume that you’re wrong in your view that the price of gold is going to fall next week. After selling your 100 grams of gold, you check the price next week and find that it has increased by $1 instead of decreasing by that amount. So you buy your gold back at a loss of $100 or 2.4 grams of gold. You began with 100 grams but now only have 97.6. That’s a loss of only 2.4%.
Now let’s take the second example. You set aside 5 grams as margin and borrow 1000 grams, which you sell into the market. Next week, you realize with horror that the price has risen by $1/gram. You immediately buy back the 1000 grams of gold at the higher price, losing $1000 in the process. In order to cover your loss, your broker sells 24.03 grams of the gold in your account. You started off with 100 grams, but now you only have 76.97. That’s a loss of 24.03%!
That’s right, even though you only had to put up 5 grams as margin to cover a 1000 gram trade, any losses you accrue in the trade get taken out of the remaining gold in your account. So you can lose a lot more than 5 grams if the trade goes against you.
This is why people often criticize leveraged trading as being too risky. Although leverage can allow you to have greater gains off of small fluctuations in price, it can also allow you to take greater losses.
So let’s get back to our original question: How can you use leverage to your advantage instead of allowing it to use you?
The Two Keys to Successfully Trading With Leverage.
There are two keys to answering this question, both of which are related to each other. The first key to making leverage work for you is to always place stop losses. Every time you make a trade using leverage, you should simultaneously place an order to exit the trade if the price goes too far against you. The distance between the current gold price of the asset you are trading (or current dollar price, if you are borrowing dollars to make the trade) and the price where your stop loss is placed can be multiplied by the amount of the asset you are buying (the “position size”) to produce the “amount risked”.
And this gets us to the second key to making leverage work for you: risk management.
You see, no one really knows which way the market will go. What we do know is that it is likely to go up to one level, but if it doesn’t then it is likely to go down to this other level. So the “science” of trading is not about actually predicting the movements of prices. It’s just about predicting the most likely path of prices, along with the second-most likely, third most-likely, and so on.
We can then use this knowledge to determine how much of a reward it is reasonable to believe we will make from a trade and how much we will have to risk in order to have a chance at earning that reward. This is all there is to trading.
The key to being successful at trading, therefore, is to make sure that the rewards always outweigh the risks. Preferably, you want the possible reward from a trade to be twice the risk. But even if you are willing to trade under less favorable circumstances, the risk/reward ratio should at least be greater than 1:1. Any less than this and you are gambling, not trading.
So how can you know if a trade has a 1:2 risk/reward ratio? I learned a long time ago that it is just too difficult to try to calculate how much of an asset to buy and where to place my stop-loss in the heat of a trade, when emotions are running high. So I use the free risk management tool from Fotis Training Academy. You can find it here.
How to Get Started.
If you want to get started trading gold/USD with a gold-denominated brokerage account, you can use this link to get a 15% deposit bonus (assuming you reach their volume requirements) when you open one with FXChoice. They offer 1:200 leverage.
If you’re not sure whether you want to use FXChoice, you can learn more about them here.
So get busy multiplying your gold. 😉