Some traders strongly believe that “high” leverage is bad, and “low” leverage is good and less risky.
Although it is not the true definition of leverage according to Investopedia, I am going to use C2 definition of leverage (capital allocated to a trade divided by total trading capital available).
Now consider the following scenario, it will show that there is no such thing as “good” or “bad” leverage.
Take a coin, toss it in the air 100 times. The ratio of heads to tails landing up should be very close to 50/50. If you were to win $2.00 every time the coin landed heads up and lose $1 every time heads landed face down, you should have won approximately $50 by the end of 100 tosses. This is a positive expectation situation. The odds of you winning are heavily in your favor. We will further say you have $100 to bet with.
The question is, what percentage of your money should you risk on each flip of the coin?
What would you say is the best percentage (leverage) to reinvest on each flip?
10%, 25%, 40% or 51%?
This means that if you begin with $100 and choose to risk 10% of your capital on each flip, you begin by risking $10 on the first flip. If the coin lands heads up, you win $20. You would then risk $12 of the new $120 total on the next flip of the coin. If you lose, you lose $12 and if you win, you win $24 and so forth.
Would it make a difference which % (leverage) you used? If so, how much?
Remember, you make twice as much when you win than when you lose. The odds of you winning are 50% every time. The answer may surprise you!
By risking 10% of your money on each of the 100 flips (a $10 bet on the first flip) you will turn your $100 into $4,700! Higher leverage increases your return from 50% ($50) to a 4700% return!
Reinvesting 25% of your money (an even higher leverage) would have turned $100 into $36,100! An increase of just 15% per toss increases your total return from 4700% to 36,100%.
It looks like it gets better the more you invest, right ? So more leverage is good, right?
But wait. Increasing your risk another 15% every flip to a total of 40% being risked on each flip would turn your $100 into $4700. This time by increasing your risk (leverage), your return dropped drastically!
What if 51% of your money is invested? With this scenario, you actually lose money even though the odds are statistically in your favor. Your $100 decreases to $36. A loss of 64%!!
As you can see, there is no “good” or “bad” leverage, only optimal leverage.
And again, as previously mentioned, only a backtest can give us the optimal leverage to use.
The concept behind this simple head or tail game can of course be applied to any trading system with a positive mathematical expectancy (also called trading edge).