Friday, August 28, 2015

Leverage and Volatility

Suppose a trader predicts a given stock to rise by 25% over the next 10 days. Of course, if he is unleveraged, if the stock does indeed rise by 25% in 10 days, his 10-day return will be 25% irrespective of how volatile the stock price was in the interim. This, however, is far from true were he leveraged ( on margin, as opposed to trading unleveraged while taking outside loan for providing capital). If he was 300% leveraged, then his return at the end of 10 days, is far from 100% (4 times 25%) as one would naively imagine, but a devastating -47%, in the volatile scenario 1. It is only in the non-volatile scenario 2 that leverage actually multiplied his returns.

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