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Does Leverage Hurt? It can!

I have had some discussions about leverage and its affects on drawdowns. I am of the opinion that more leverage increases the chances you have a larger drawdown. Those that already agree with me are thinking, “duh!” However, many people have different opinions. I certainly am biased since I have my own strategy I publish here, but I wanted to attempt looking just at the data.

I went to the grid and copied all columns and data into excel. Unfortunately, at this moment 100 of the nearly 700 strategies wouldn’t show on the grid and gave me a blank page so I skipped it. I then removed all options strategies, because the data did not seem consistent for them in regards to leverage.

So this chart is based on strategies that only trade stocks, futures, or forex. There were 505 strategies in the data which I categorized into different leverage usage categories. There is no doubt some survivor bias by taking data from the grid. So I think if I could adjust for that the results would be even more extreme.

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Here are three charts separated by Futures only, Forex Only, and Stocks Only



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Trader A allocates 100% of his capital to a blue chip stock and his stop is 1%.
Trader B allocates 10% of his capital to the same stock but is willing to risk 9% of his capital on the trade (9% stop).

C2 leverage for trader A: 1.00
C2 leverage for trader B: 0.10

Now are you going to tell me that trade B is less risky than trade A simply because its leverage is 10 times smaller?

Seriously.

Your studies only reveal one thing: when some traders allocate a bigger % of their capital to a trade (what C2 calls leverage), they use larger stops (for whatever reason), period.
And of course larger stops create bigger drawdowns, it is that simple.

Since I can’t imagine anyone having a 90% of trade capital stop, I am assuming both stops are % of trade capital not total equity capital. To answer your question it could be different depending on the scenarios but Trader B actually has lower risk in my opinion. Let me prove it.

Assume we are both day traders that don’t hold overnight. You are trader A and I am trader B. We both trade ZIV and allow ourselves to take just one trade a day. All numbers below actually occurred just yesterday for ZIV according to my ThinkorSwim charts.

  1. We both buy 1 share of ZIV at the price of $32.09 at 8:34 AM.

  2. At 10:08 AM two other market participants that don’t include us make a transaction at $31.81. Now both of us are down -0.87% on the trade. Of course my total equity drawdown is only 1/10th of yours at this point.

  3. You are very close to your stop. My stop is not close to triggering at all. The price would have to drop all the way to $29.20 to trigger my stop of 9% of the trade. Even if it did drop to there, it would still only be a 0.9% total equity drawdown.

  4. The next trade of ZIV occurred at $31.65. There was one trade of 100 shares that actually transacted at that minute.This triggers your stop order and your broker will take the next available trade.

  5. The next trade occurred at $31.63, which is the price you would actually get filled at. You have a trade and total equity drawdown of 1.4%

  6. I end up having a larger trade drawdown when the price of ZIV hits a low of $31.59, which equates to a 1.6% trade drawdown but only a 0.16% total equity drawdown. The price of ZIV would have to drop about 10% for me to have the same total equity loss as you had.

  7. Since we are day traders and my stop hasn’t filled I end up having a market on close order fill in the last moments of the day getting me out at around $32.14.

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Stops are a huge factor in trading. Leverage isn’t everything, but sure seems like there is a correlation between drawdown and leverage from my earlier charts. I don’t know of a way to check who did and didn’t have stops in the data, that would certainly change the results in interesting ways. Stops don’t just mean you can use whatever leverage you like with the same level of risk. I know you likely still won’t agree with me, but I think the math of this real world example is very sound. So I doubt there is anything I can do to change your mind or for you to change mine. However, I wish you the best, and I really hope you see that I only want you to come to my point of view because I think you are overlooking some risks that could hurt you.

Cheers!

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No, both stops are % of total trading capital of course.
Trader A is risking 1% of his entire capital while trader B is risking 9% of his entire capital.

That means trader B will lose 9 times more money if his stop is hit.

And yet, according to C2 leverage, trade B seems less risky because the “leverage” is 10 times smaller for trader B, because it simply divides the trade capital by the total capital.

A fixed stop (like 2%) allows the trader to pyramid his profits when his equity grows. On the other hand, if his equity plummets, less and less trading capital is allocated to each trade, so the losses become smaller and smaller.

However, when the trader allocates more and more trading capital to each trade (because now he is using his profits to make even more money), C2 will show an “increase” of leverage in his track record and such system will be considered “risky”, which is only an illusion, since the trader is never risking more than 2% of his total trading capital on each trade (via his stop).

We are of course assuming that the trader always uses a stop : mental stop, hard stop, trailing stop, volatility stop or put/call options.

Best of luck too.

Gotcha. I don’t know why someone would bother making a stop if they were going to let the price drop 90% below their purchase price before getting stopped out. However, even with that scenario which seems rather unrealistic to me, there are many ways in which Trader B is better off than Trader A especially if we get into holding overnight, which I myself do every day. Again there are scenarios where Trader A would have a lower drawdown/make more money. However, my point is that only with Trader B is the max loss truly capped at 10%. Most of the time Trader A will have a max loss of 1% of total capital but that is not guaranteed.

For example, twice in the last 3 months ZIV has dropped more than 10% from close to open overnight, which means C2 autotraders following a strategy that holds overnight would lose more as trader A than trader B. For example, Trader A holding overnight on 3/6 would have a 17.38% total equity drawdown. Holding overnight on 3/13 would have produced an 11% drawdown for trader A. In both cases for Trader B at the same time the drawdown would only have been 1/10th of that. Final or max drawdown for Trader B would depend on trading strategy and further analysis but it would be capped at 10% of portfolio since only 10% of the portfolio was allocated to the trade. Of course it would take a 100% drop in ZIV to hit that 10% of caPital loss.

Furthermore, in the last three months there have been 16 times ZIV would have dropped down more than 1% overnight with the average drop being 5%. Again in each case over that same period the lower leverage would have had 1/10th of the drawdown over that same time period.

Stops and Leverage Matter! In your first example you adjusted both variables (stops and leverage) to force a point. To isolate the affect of leverage a better example would be to have both stops be 1% of total capital. In which case whether there is a gap in regular hours or after hours the one with the lower leverage will have the lower drawdown.

I am not against the total use of leverage. I use it myself! However, I think I increase my risk by using it. I just believe defining risk on stops alone and saying leverage isn’t relevant to risk is an oversimplification. Both affect risk as do many other things. I certainly hope you agree. That is okay if you don’t, but I think I have spent all the time trying to bring you to my side that I can. It is only about the third time you and I have had this conversation haha! I wish you the best. You may have the last word on the topic. :slight_smile:

True, but the trader cannot just give them some arbitrary value.

The optimal percentage of trading capital that we need to allocate to each trade and the optimal stop (in % of total trading capital) must be determined by the backtest, and the backtest only!

If the trader uses any other value - other than the optimal value - the performance of his system (in terms of drawdowns and ROI) will quickly deteriorate or even become negative.

In other words, there is no “good” leverage number that we can use at all times, only the backtest can give us the optimal leverage to use for maximum performance and minimal risk.

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