Undercapitalization

Undercapitalization is closely related to leverage, since, contrary to what many people believe, higher leverage actually increases risk-capital requirements. While the broker allows the client to control higher amounts through less initial capital through high leverage, because price swings are amplified in the process, the trader has to increase his capital that he deposits with the broker in order to survive periods of high volatility (in other words, wide price fluctuations).

Leverage increases the amount of loss or gain that a trader must experience. When the account is registering a positive unrealized return, leverage, and price fluctuations will not cause much problem since they're absorbed by the unrealized profit. When the account is in the red, however, undercapitalization becomes a problem, because even if the price eventually moves in the direction that the trader anticipated when opening the position, the amount of risk capital (in other words, margin) may not be enough to absorb the temporary fluctuations in the meantime.

What use is a successful prediction of market direction if you will never be able to survive the inevitable price fluctuations in between? What use is a complete and well-thought analysis if your capital allocation doesn't allow that analysis to bear its fruit?

Leverage amplifies volatility, and thus increases the initial deposit that must be maintained. But we had said that leverage allows the trader to control large sums through lesser initial deposits. What is the whole point of this circular game? So we reach back at what we argued at the opening of this section: Overleverage is wrong, and must not be used except in very unusual circumstances.

Next: Money Management