Why leverage matters

This is reprinted with full attribution from the excellent blog oftwominds by Charles Hugh Smith:

The Wonders -- and Risks -- of Extreme Leverage


March 14, 2008


With highly leveraged funds blowing up left and right (Carlyle Capital in Default, on Brink of Collapse (link courtesy of correspondent Azvitt), it's timely to look at an illustration of how leverage can be exploited in a rising market.
We turn once again to frequent contributor Harun I. for an explanation--and insights into how quickly the profits gained by such extreme leverage can not just vanish but turn into stupendous losses. Harun has also kindly provided a chart of the soybean commodity contract, which illustrates how leveraged wealth can turn into losses in one day.



Here is Harun's example:

One of the trading strategies in some of the commodity trading courses on the markets is what is called inverted pyramiding. It works like this:
Let's assume that a contract of soybeans is trading at 5.50 cents per bushel and that the performance bond (margin) to control this contract is $1800 dollars.

So I buy one contract. Since every one cent change in price equates to a $50 dollar change in value of the contract, in order to purchase another contract price has to move 36 cents in my favor (36 x 50 = 1800). If I want to continue to add contracts this way it would look something like this:

#Contracts Price Profit
1 5.50 0.00
1 5.86 1800.00
2 6.22 3600.00
4 6.58 7200.00
8 6.94 14400.00
16 7.30 28800.00
32 7.66 57600.00
64 8.02 115200.00
128 8.38 230400.00
256 8.74 460800.00
512 9.10 921600.00
Let's stop here. So far it seem like a ton of fun. Almost $1 million in paper profits with only $1800 invested in about a years worth of time. (emphasis added-CHS)

But let's look at the reality of this situation. Leverage cuts both ways.

Let's say the market opens locked limit down (50 cents); what are my losses?

Well 1 cent = $50 so (50 x 50) x 512 (number of contracts) = $1.28 million - $921,600.00 = $(358,400)

Obviously this is reckless and yet this is the type of problem being faced by banks and hedge funds today.

This is why your projection of 4% of the housing market wreaking havoc with the whole economy was spot on.

This is why the Fed, the Treasury, and the banks are in abject panic.

Now that we have seen the beast (leverage) has claws and fangs, this does not necessarily mean we should go screaming into the night. We must respect it and protect ourselves to the greatest degree possible.

Thank you, Harun, for illustrating how leverage can be extended, and what the consequences can be.