Quote from dancalio:
I'm trying to understand how trading with so much leverage works. Don't fairly common down ticks completely wipe you out?
I cannot really comment on the truly high levels of leverage, but I can say that intraday trading is not quite as risky for a firm as you might think, for the following reasons:
- Risk control. A day trading firm will typically place limits on the allowable losses for a trader. This does not protect against stock halts, unexpected gaps, etc., but it does reduce one common source of "blow-up" by a trader. For example, an undisciplined trader might refuse to cut the loss short at some point, might average down, etc., but could potentially be prevented from doing so by risk control software (e.g. closing orders only at a certain threshold).
- Time factor. I would say that the potential for profit and loss increases with the length of time. In other words, given a risk control system, it is much less likely to experience a large loss if the loss is cut (position closed) rapidly once "x" criteria is hit. Similarly, it is typically fairly unlikely to see a large instantaneous profit once a position is opened, it typically takes some time to develop.
- Diversification. A trading firm is likely to have traders trading a fairly wide variety of securities at any given time. This is less risky than, say, all traders holding the same position in the same security at once (fairly unlikely).
- Previous profits. A trader taking a large loss is fairly likely to have a series of relatively large gains in the past, which provides some cushion against a loss. This is an element of risk control, in that trading firms often base current risk criteria on the past performance of a trader.
- Profit splits. Taking a portion of all trading profits and holding traders responsible for full losses means that a trading firm should likely have some extra capital in the event of large trading losses. One could look at it as part of the cost of doing business.
The situation for the individual trader is a bit different, and leverage can indeed be a bad thing if used unwisely. One method of reducing this risk somewhat would be to scale into and out of positions, as well as to cut losses very rapidly. For example, a trader that scales into a position as it moves in the correct direction would have a lower risk profile than a trader that goes "all in" at the time of opening a trade.
