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One should target volatility, not leverage. Without leverage, you can usually only take the most risky of strategies in order to get a return. If you're willing
by smabie 6y ago
One should target volatility, not leverage. Without leverage, you can usually only take the most risky of strategies in order to get a return. If you're willing to take on leverage, you are much more likely to find a good strategy.
Source: work at a small prop firm that takes on around 10x leverage. Even at this leverage ratio, we are considerably less risky than the S&P 500. Even at 10x, our volatility is somewhere between 1/2 to 1/3 of the S&P.
If you take on very little directional risk and are doing stat arb like us, there's nothing wrong with taking on a lot of leverage. Even at 10x, we are safer than the vast majority of retail portfolios in existence.
Leverage (through futures, options, shorts, or borrowing) is the cornerstone of almost all active outperformance in the industry. Without leverage, you will be forced into high beta names that trade at a premium compared to their risk adjusted return. See the "low beta anomaly" for more information.
- marvin 6y agoAnd certainly you are well protected against black swan type events, even at 10x leverage...?
- paulpauper 6y agoit really depends on the underlying asset. short dates bond trading involves large leverage because short-term bonds tend to not move much
- smabie 6y agoShit happens and even the smartest people can get fucked, just look at the LTCM blow up. So of course it's possible. It's impossible to eliminate all risk, regardless of the leverage ratio. I'm just saying that leverage isn't a reasonable proxy for risk. You have to dig deeper.
- marvin 6y agoThat sounds reasonable at first glance, but it would be really interesting to see a proper study of leveraged investments throughout the modern era, and their tendency to blow up compared to the volatility of what would be the reasonable alternative.
- ouid 6y agoif you have 10x leverage, your insurance against black swan events is to try to go 10x bankrupt.
- Def_Os 6y agoBut increased leverage doesn't mean your risk-adjusted returns are any better.
- smabie 6y agoYou can't eat on risk adjusted returns alone! gotta make that chedder But leverage necessarily decreases your risk adjusted return assuming non zero volatility of the strategy. This is called "volatility drag."
- mezod 6y agowould you recommend any literature more broadly argumenting the ideas you defend here? thanks!