Reserves are funds in our account that are held back
from trading, and usually parked safely on the sidelines in risk-less
money-market instruments. The effect of holding reserves is to reduce net
leverage. A workable rule of thumb that has evolved over time out of the real-world
trading arena is to limit net leverage to 30%.
To see how reserves, leverage and net leverage work
together, employ the following formulas:
Reserves = 100% - (Net Leverage / Leverage)
Net Leverage = Leverage * (100% - Reserves)
Leverage = Net Leverage / (100% - Reserves)
where
Reserves are cash or cash equivalents held back on
the sidelines.
We can solve these equations to find any of these
numbers. For example, for a stock position where initial margin and leverage
are both 50% and net leverage is held to 30%:
Reserves = 100% - ( 30% / 50% ) = 1 - 3/5 = 1.00 -
0.60 = 0.40 = 40%
For stocks, if we deposit initial margin of 70% into
our account and confine our use of net leverage to 30%, as recommended, then
Reserves = 100% - (30%/30%) = 1 - 3/3 = 1.00 - 1.00 =
0%
If we entered a futures position using 75% leverage
(and, of course, putting up 25% initial margin, which represents 100% minus the
75% leverage), and if the total value of this position amounted to only 40% of
our available trading capital (therefore, we are holding back 60% of our
trading capital in reserves on the sidelines), then the net leverage would be
reduced proportionately to 30% (that is, 75% times 40%). Using the second
formula,
Net Leverage = Leverage * (100% - Reserves)
Net Leverage = 75% * (100% - 60%) = .075 * 0.40 = 30%
Again using industry standard (and quite reasonable)
rules of thumb, if we wish to keep net leverage at 30% while holding 60% of our
capital in reserve, we can put up 25% margin for each contract, and therefore
employ 75% leverage for each contract. Thus, using the third formula,
Leverage = Net Leverage / (100% - Reserves) = 30% /
(100% - 60%) = 75%
It has long been known that money management is the
most critical consideration in trading and investing. Money management includes
the prudent use of leverage. Sound rules and disciplines allow success to
accumulate while minimizing the risk of ruin.
