I’ve been having a great back and forth conversation here with a member of our community regarding that which must not be named.  Just kidding, we can call it by name.  We’ve been talking about LEVERAGE.

Now you can’t technically trade options with leverage, but what some traders try to do to simulate leverage is trade weekly options.  That way you can get 4 times the number of trades in compared to using one monthly cycle.

 

So the question is, should we expect this to dramatically increase the performance?

 

Before we try to answer that, something that people often overlook when adding leverage is, sure it will increase your performance during good times and you may look like a hero for a short while, but by very definition it will also amplify your losses.  Eventually we should expect some or all of those gains to be given back.

Here’s a chart of the S&P 500  (SPX)  with 1x and 3x leverage for the last 7 years:

 

So it certainly does appear that adding leverage is the solution to the somewhat low return of the S&P 500.  But of course if we stretch that out back to 2004 to include some major drawdowns as well, we see why this isn’t a solution at all:

 

Actually since losses are more costly to a fund than gains are beneficial, in the long run adding leverage will only hurt the performance.  At every “choke point” after a drawdown, the leveraged strategy may be lower each subsequent time.

 

Now getting back to leveraging option strategies by trading weekly cycles rather than monthly cycles.

Since taking 4 times as many trades won’t change the win / loss ratio, and statistically speaking even the best option traders in the world will go through a bad month or two when markets don’t cooperate, taking 4 times as many trades isn’t likely going to do much to the results. It’ll likely lead to:

 

–  Better performance in good months

–  Amplified drawdowns in bad months

–  In the long-run, not much changes.

 

Leverage only works on strategies with extremely low drawdowns and very few if any losing months.  For example adding leverage to a money market fund may be more effective than adding leverage to a volatility ETP strategy.  The former may actually benefit, but the latter will surely be punished.

 

In the end my general opinion of leverage is that it should never be used under any circumstances, full stop…

 

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