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).