Does Leverage Magnify Returns as Well as Losses?
It is often said that leverage can increase your potential returns and your potential losses. What is often missed if that this is not a linear relationship. While you can increase your returns with more leverage, it comes a point when this is counter-productive. In other words, past point X, for 1 unit of risk you don’t get a 1 unit of return anymore.
The Gremlins of Volatility
This asymmetric return works in three ways. First, increasing leverage always increases the volatility of your trading returns. These are our first gremlins, the gremlins of volatility. Take a look at our first picture below. This simple table showcases two hypothetical systems A in the first column and system B in the column below it.
System A makes 20 percent one year but loses 10 percent the next. System B on the other hand consistently makes 4.5 percent each year. Obvi…