Leverage increases profits exponentially. Here, for example, a leverage multiple of 4 more than triples expected gains per year and increases cumulative gains more than five times over the test period.
But here's the catch. At five and beyond, you enter nosebleed territory. Drawdowns start to exceed 50%. These are very difficult pysychological 'loss' levels to tolerate, especially when you have bought your position at the top of the peak before the drawdown.
Leverage crests at 7 times. Beyond that, the favorable impact on ballooning profits starts to diminish vigorously, and drawdowns swing into very high double digits. Beyond leverage 12, you are busted, ruined, killed, game over.
The land of leverage is a region off limits for most. Some of the best brains in the world have gotten financially killed here (using some reported leverage levels in excess of 100--"whom the gods would destroy, they first make mad"). Some of the strongest-stomached, boldest-hearted, super-confident, hedge-fund operators have been murdered here--and buried unceremoniously by the banks. (These days some of them may get buried too.)
Oh, by the way, you get to these killing fields, or slopes, of glory using derivatives. Mostly options, futures, and swaps.
Comments
2/21/2008 6:20 p.m. ET
2/27/2008 1:50 p.m. ET
Kinda looks like a cathedral,
or the Hagia Sophia, doesn't it?
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