What is leverage?

Most people who are interested in investing in the stock markets do so on cash basis. This means that for every $1,000 they deposit into their brokerage account, they get to buy $1,000 worth of shares. This is in strong contrast to how forex traders operate. Forex traders usually trade on leverage.

Leverage is just a fancy term for borrowing money from the broker and then using the borrowed money to trade. It's trading on credit, by depositing some money into an account and then using the deposit to borrow more money. The amount of money that traders borrow depends on the market that they want to trade, the amount of money the broker is willing to lend and how much risk the trader is willing to take.

Popular Forex brokers offer many tiers of leverage, from 1:10 to 1:100. Meaning that for every $1 a trader deposits, the broker is willing to lend $10 or $100 respectively.

Trading on leverage is often cautioned against because it amplifies both losses and profits.

Leverage and equities

Trading with leverage is less popular in equities, and stock brokers offer far less leverage than is available to forex traders. Popular amounts of leverage range from 1:2 to 1:4. Trading on 1:4 leverage in equity means that a 5% rise in prices is a 20% gain in equity value of the account. Conversely, a 10% drop in prices correlates to a 40% loss in the trader's deposit.

With the numbers out of the way, let's investigate what returns and drawdowns we can expect when using 1:2 leverage and 1:4 leverage for purchasing ETFs.

Parameters and code

Initial investment: $10,000
Investment period: 15 years

val initialInvestment: Double = 10_000.0
val years: Long = 15
val startDate = LocalDateTime.now().minusYears(years)
val leverage: Double = 1.0

val data = loader.download(etf).dropWhile { it.datetime.isBefore(startDate) }
val closePrices = data.map { it.close }

val equity = closePrices.asReturns().equityCurve(initialInvestment, leverage = leverage)
val drawdown = equity.drawdown()

chart("Buy and hold - ${etf.tickerName} - Leverage: ${leverage}") {
    panel() {
        xylinechart { equity.toXYSeries("Equity") }
    }
    panel(height = 200) {
        xylinechart { drawdown.toXYSeries("Drawdown") }
    }
}

Let's observe the outcome of investing with and without leverage in SPY, QQQ and VTI.

SPY - SPDR S&P 500 ETF Trust

SPY - Buy and hold, no leverage

SPY - Buy and hold, 1:2 leverage

SPY - Buy and hold, 1:4 leverage

QQQ - Invesco QQQ Trust

QQQ - Buy and hold, no leverage

QQQ - Buy and hold, 1:2 leverage

QQQ - Buy and hold, 1:4 leverage

VTI - Vanguard Total Stock Market Index Fund

VTI - Buy and hold, no leverage

VTI - Buy and hold, 1:2 leverage

VTI - Buy and hold, 1:4 leverage

Results

Conclusion

Drawdowns for leveraged long-term positions are extreme. Losing 80% of portfolio value or more during a drawdown is not to be taken lightly and few people have the stomach to stand by and watch such severe changes in their portfolio value. Additionally, the largest drawdowns take years to recover from.

In my mind there is no doubt that leverage lives up to its dangerous reputation and that it should be approached cautiously.