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.
http://www.forexfactory.com/pics/art...bert_colby.jpg
Robert W. Colby
TradingEducation.com
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.
http://www.forexfactory.com/pics/art...bert_colby.jpg
Robert W. Colby
TradingEducation.com