Leverage in trading allows investors to control larger positions with a smaller amount of capital. As a result, leverage can amplify potential returns but also increases the potential for losses. Using a leverage ratio of 10:1, for example, an investor can trade with $1,000 worth of assets by depositing only $100. Hence, a 10% change in the asset’s value would result in a 100% return on the position’s value. However, it also means that if the prediction is wrong, the potential loss is also 100%. Therefore, it’s essential to remember that leverage increases risk and the potential for losing your entire capital. Due to that increased risk, investors like Ray Dalio are averse to leverage:
“Using leverage is like playing Russian roulette. It means that you are inevitably going to get a bullet in the head.”
As we wrote in our previous article, Leverage Trading is A Double-Edged Sword. You might amplify your returns in a bull market significantly but also lose your entire capital due to unforeseen market movements. As you can see from this example on Reddit, a trader lost $450.000 in 4 Days as he did not anticipate the crash of Lucid (LCID). In this case, he traded approximately 2.5M on margin and 7x leverage.
Another vital thing to consider is the control over trade size and risk management. As one of the most cited investors in history, Benjamin Graham, pointed out that avoiding losses takes priority over improving gains:
“To make up for a 95% loss in value requires the investor to make an astounding gain of 1900%.”
“Assume an investor buys a stock at the peak of a bull market that can generate 5% above average market returns. The bull market ends, and the stock drops by 50% the following year. Even if the stock gains 10% every year, it will take beyond 16 years to overtake market returns.”
So even if you have multiple wins in a row and can multiply your portfolio by 100%+, one bad trade can ruin your whole portfolio as you will most likely not be able to recover from a 95% loss. A monumental example of leverage gone wrong was when 3AC, a crypto hedge fund with 10 billion at peak, lost all its funds due to an overleveraged position in a failed crypto project.
Another notable example is Bill Hwang, who lost $20 Billion in two days due to overleveraged positions.
Using leverage is undoubtedly a controversial topic in the financial world, and some might say that using leverage goes against the potential for long-term and sustainable growth. For example, Berkshire Hathaway has stated against using leverage in trading. The letter, which was released in 2017, highlights the potential risks and drawbacks associated with leveraged trading, particularly when it comes to long-term trading and sustainable growth. Moreover, the statement, sure to spark debate among traders and investors, serves as a reminder of the importance of considering the long-term ramifications of using leverage.
“Berkshire, itself, provides some vivid examples of how price randomness in the short term can obscure long-term growth in value. For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest work its magic. Year by year, we have moved forward. Yet Berkshire shares have suffered four truly major dips. Here are the gory details:
This table offers the strongest argument against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and the plunging market doesn’t immediately threaten your positions, your mind may be rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”
The main challenge of trading without leverage is that it takes time to accumulate significant returns. That is why a survey has revealed that an increasing number of retail investors are turning to leverage to boost their investments. The study found that 40% of investors reported taking on debt to invest, with an exceptionally high proportion of Gen Z investors (80%) using leverage. This trend is not limited to small borrowing amounts, with nearly half of those surveyed (46%) reporting borrowing $5,000 or more.
Another Challenge of trading without leverage is that you need a more extensive capital base to trade larger positions. Again, especially for young people, this can be challenging when they are starting.
Hence, some experts argue that using leverage correctly can be an effective tool for portfolio growth, especially for young investors who may need more cash. According to a 2008 paper by Yale professors Ian Ayres and Barry Nalebuff, it can be responsible for young investors to use leverage to maintain a larger exposure to stocks but gradually decrease this leverage as they get older. This approach can lead to better risk-adjusted returns over time.
“The expected retirement wealth is 90% higher compared to life-cycle funds and 19% higher compared to 100% stock investments. The expected gain would allow workers to retire almost six years earlier or extend their standard of living during retirement by 27 years.”
Investors are increasingly turning to leveraged ETFs to amplify returns on their investments. These ETFs use debt and derivatives to leverage the performance of an underlying index, such as the S&P 500. One example is ProShares Ultra S&P500 (SPXU), which aims to deliver twice the daily return of the S&P 500. Leveraged ETFs work especially well in cases of bull runs. Thus, if you trade without leverage, you might miss out on opportunities, especially in highly volatile markets.
Risk management is a crucial aspect of trading, and there are several strategies traders can use to keep their losses in check:
Set realistic stop-loss levels, and don’t go too far below market price. A standard method for determining points is using moving averages, as they are simple to compute and widely monitored by the financial market. If you’re feeling anxious about a stop-loss level, it could be a sign that you’re trading outside your comfort zone. For more information, read our “5 Tips for Using Protective Stop-Losses” article.
According to many renowned investors, controlling one’s emotions is crucial to managing one’s finances effectively. The adage goes, “if you can’t control your emotions, you can’t control your money.” This sentiment highlights the importance of emotional intelligence in investing and serves as a reminder that success in the financial industry requires a solid understanding of financial concepts and the ability to navigate the emotional pitfalls of managing money. Keeping out emotions is one of the most underrated advice for investing. Unfortunately, that may also explain why very smart people do not always do well in money management:
“Why do MBAs and other smart people not do well in money management? People invest in their emotions. They process information differently.”Joel Greenblatt’s audited class notes
Primarily novice traders should focus extensively on risk management by limiting the percentage of capital risked per trade to survive long enough to gain mastery as a trader. On the other hand, experienced traders may take more risks to make greater profits, but they have the methods and experience to do so.
In his book “Principles,” released in 2017, renowned investor Ray Dalio refers to diversification as the “Holy Grail of Investing.” According to Dalio, most people have a mistaken understanding of diversification, believing that choosing different assets within the same class is enough to protect their portfolios. However, Dalio states that individual assets within an asset class are usually about 60% correlated with each other, meaning that true diversification requires a combination of uncorrelated return streams. Dalio recommends a handful of good, uncorrelated investments that are balanced and leveraged well to achieve this. By doing so, investors can dramatically reduce their risks without lowering expected returns, ultimately maximizing both short-term and long-term returns.
Dalio’s All Weather portfolio looks similar to this:
To diversify your portfolio further, you could add cryptocurrencies or investments in illiquid assets such as real estate or art collections.
Tip: Use Morpher, as you can invest in over 700+ assets, including indices, stocks, cryptocurrencies, commodities, and art collections. Almost no other trading platform can enable such a diversified portfolio. Moreover, you can also decide to short or long the market depending on the market state of the asset class.
In conclusion, trading without leverage offers several benefits, such as reducing the potential for significant losses and allowing for a more conservative approach to the market. However, it also presents challenges, such as potentially lower returns and the requirement for more initial capital. Despite these challenges, it is essential to remember that understanding and managing risk is crucial in any trading. Therefore, whether using leverage or not, it is necessary to have a solid understanding of the risks and a plan to manage them. Ultimately, the decision to trade with or without leverage should be based on an individual’s risk tolerance and investment goals.
Disclaimer: All investments involve risk, and the past performance of a security, industry, sector, market, financial product, trading strategy, or individual’s trading does not guarantee future results or returns. Investors are fully responsible for any investment decisions they make. Such decisions should be based solely on an evaluation of their financial circumstances, investment objectives, risk tolerance, and liquidity needs. This post does not constitute investment advice.