In algorithmic trading, Leverage and margin can be considered as ‘friends’ which does provide opportunities to increase the returns on investment, but at the same time it also increases the risk. If these risk factors are ignored, it can result in severe leverage and margin problems that become difficult to deal with in the long term. This article seeks to understand what leverage and margin are and how to discipline them.
Leverage as we all know allows us to purchase more than we own without actually owning more funds which gives us a greater shot at number of options. Its a tradeoff because having more at stake puts many at risk too. So for instance leverage can be expressed as a ratio such as 50:1.
Analogy: An individual possesses only $10,000 and with 10:1 leverage, that individual will be able to make investments of upto $100,000.
So what is margin?
In layman’s terms, margin is simply the funds a trader must put in order to open and hold a leveraged position. From the perspective of a broker, this is a security, and in most cases, it is expressed as a percentage of the total amount of the trade.
For example, if the margin requirement is set at five percent, a trader is obligated to deposit five thousand rupees to have control over a position worth 1 lakh.
The margin can be considered as the apparent top tier of funds that are needed to maintain the account, margin and leverage have a close relationship. For the purpose of expanding exposure in the account, increased leverage is often used however this can result in leverage problems in the latter parts of investing.
Bulking the risks without supervision is only going to lead to excessive issues pertaining to leverage which is counterproductive especially during algorithmic based trading since it is based around the principles of automation and high volume trading.
Margin Calls: Establishing margin requirements means that brokers will be able to close any positions that do not comply with the account equity.
Increased Volatility Exposure: When over-leveraged, algorithms may bear higher risks when market changes occur.
Effective management increases the chances of a trading strategy being sustainable and profitable.
Key Risks Associated with Leverage and Margin
- Over-Leveraging
Taking up too much leverage can be catastrophic especially if trades do not go in your favor.
Impact on Algo Traders: Most algorithms would trade singular trades with small asyncio nano time profitable returns. This means that over-leveraging means diminishing the profits quickly.
- Margin Call
A margin call is the decrease in account equity that falls short of maintaining the margin required.
Impact on Algo Traders: When an unexpected custom liquidation triggering event occurs, algorithms do not anticipate it which in turn alters the trading strategy.
- Increased Costs
Interests from borrowing assets are not always easy to pay back which decreases the net profit and the higher leverage does not help the situation either.
- Emotional Decision Making
People managed accounts that are over-leveraged will require human interaction which may be tempting, however tempting to trade but traders should abstain as algorithms do not have this emotional issue.
Strategies for Managing Leverage and Margin
- Set Leverage Limits
Wind up drawing leverage maxes based on the trade strategy and how much risk you are willing to accept. Using lesser leverage increases the chances of massive losses occurring again.
Example: Countries and India allow for scalping which usually includes high leverage for fast trade/ selling while swing trades use lower leverages.
- Keep a Close Eye on Margin Levels
Tip: It is advisable to leave a buffer above the maintenance margin to avert automatic closure of trades.
- Spread Your Positions
Try to make a number of trades in different assets or markets to mitigate the consequences of a certain negative movement.
- Adjust Your Trade Size
Position size calculators or algorithms can be used to make sure that the degree of leverage is in accordance with the account equity to the size of the trade made.
- Take Risk-Adjusted Metrics Into Account
Back test your strategies with the Sharpe ratio or the maximum drawdown ratio so that a balance between risk and reward is achieved.
- Utilize Realistic Leverage for Backtesting
Understand the losses and returns that can come with using a certain level of leverage.
Regulations and Broker Requirements
- Set Minimum Margin
This is common as regulators often want to ensure that retailers are not over-leveraging. For example, in India the SEBI has margin requirements for different asset classes.
- Rely on Your Broker
Leverage and margin requirements differ across brokers. Check whether the selected broker matches your chosen strategy and has necessary risk management tools.
- Explain to Clients the Importance of Periodic Selling
Regulators might require in a volatile market, circuit breakers which influence margin calls and over leveraged positions.
Tools for Risk Management and Automation
- Monitoring of Margin.
Integrate functionality into algorithms that aid in tracking the margin requirements and taking appropriate actions to manage them.
- Leverage Adjustment on a Dynamic Basis
Based on the market situation, use algorithms to increase or decrease the leverage employed by the trader.
- Margin Notifications
Create alerts to management which enables trades to follow up in case there is a need.
Example from the Real World
An algorithmic trader dealing with NIFTY futures employs a margin of 10,000 and leverages 20:1. The algorithm starts a trade of 2,00,000 with ten thousand as margin.
In the first scenario, the trade appreciates by two percent which leaves us with a profit of 4,000 resulting in a return on marginal investment of 40%.
In the other scenario two percent loss in the trade leads to a failure in the balance of the account below a margin. This leads the broker to make a margin call or close the deal.
This example shows the magnified effect of using leverage and why margin needs to be watched closely.
He Lets Leverage and Margin Management Work Effectively
Safeguards Investment. Keeps the loss within reasonable boundaries.
Increases Life Span Of A Strategy. Ensures that margin call do not wipe out the investment.
Aids Risk for Risk Management. A good risk for reward ratio is managed.
Beneficial for Stability. Decrease the amount of volatility registered in the portfolio results.
Final Thoughts
Outside leverage and margin, which are two of the most important aspects in algorithmic trading, they are prone to abuse and can bring forth great financial suffering. When traders set parameters on leverage, enforce rules on the amount of margin, and limit their risks, they can use these tools effectively.
In the fast-paced algorithmic trading environment, prudent use of leverage and margins is not an optional strategy, rather it is the key to remaining profitable long term.
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