Impact of Debt & Leverage in Day Trading

Leverage allows traders to amplify their potential gains from relatively small price movements in the markets.

Nevertheless, when used imprudently, leverage and debt narrow the range of market outcomes that are acceptable.

Striking the right balance between the judicious use of leverage and prudent risk controls is critical for the longevity and success of day traders.

Key Takeaways – Impact of Debt & Leverage in Day Trading

• Leverage can juice your trading profits, but excess leverage makes only the tamest market outcomes acceptable. 
• The best traders knows leverage isn’t an all-or-nothing thing.
  • It’s about optimization and capital efficiency – the balance that offers the upside while still protecting you from the downsides. 
• Evidence from ~140 500+-year-old Japanese businesses shows what makes them successful and sustainable. What do they have in common?

Overview of the Impact of Debt and Leverage in Day Trading

Role of Leverage

Leverage involves using borrowed money to increase the potential return of a trade or investment.

In the context of trading, traders use leverage to amplify the returns on their trades.

The temptation to many traders, especially those new to the markets who are heavily focused on returns rather than risks, is the goal of higher profits from smaller price movements in the market.

Risks of High Leverage

Leverage can increase returns when trades move in a trader’s favor, but it equally amplifies losses when trades don’t perform as expected.

High levels of debt and leverage can narrow the range of market conditions a trader can withstand before facing unacceptable losses.

Debt as a Risk Factor

Debt introduces the risk of default, bankruptcy, and asset repossession.

Debt makes entities more susceptible to financial distress during economic downturns or adverse market conditions.

Debt & Leverage Lessons from Japanese ‘Shinises’

In Japan, there are around 140 businesses that have been operating for 500+ years and a handful that have been in business for over 1,000 years, known as shinises.

So, despite:

• dozens of wars
• multiple emperors
• recessions
• deleveragings
• earthquakes
• tsunamis
• succession plans from one leader/ownership group to another, etc…

…they still support the financial livelihoods of their employees and owners and serve their customers generation after generation.

What do they all have in common?

Plenty of cash and cash equivalents and little to no debt.

Are they the most exciting, highest-returning businesses? No.

Everyone wants investments that compound at 20%+ per year.

But a business that returns 7% compounded for 60 years (57.9x) is still vastly better than a business that gets 20% compounded for 10 years (6.2x) then goes kaput.

Strategic Debt/Leverage Management

Balanced, Nuanced Approach

Leverage and debt aren’t a black-and-white thing.

It’s not “no leverage is good, any leverage is bad.” It’s about using it prudently.

Just as debt isn’t bad if the returns are in excess of the principal and interest paid on it.

Student loans can be a good thing if the costs – i.e., years spent, forgone earnings, debt, and interest – are paid off with the benefits – i.e., upskilling that enables them to monetize the learning and other benefits of attending.

For some, the cost-benefits make sense; for others, it’s wasteful.

There are also ways to use leverage-like techniques for both efficient use of capital and to limit tail risk (e.g., certain options strategies).

For companies, it’s about appropriate levels of debt/leverage relative to the size and stability of the enterprise.

Traders need to evaluate their capacity to service debt considering potential market volatility and personal financial stability.

Market Conditions

Traders have to be aware of the broader economic and market conditions that affect the performance of their trades.

Assets that have less duration and credit risk can be leveraged more safely (if the trader knows what they’re doing) than those with longer duration and higher credit risk.

Concept of Leverage in Trading

Capital Efficiency

The primary reason traders use leverage (debt) is to enhance capital efficiency.

By using debt/leverage, which is often cheaper than equity in terms of capital costs, traders can control a larger asset base with the same amount of equity.

This can increase returns when market conditions are favorable to them.

It can also allow for the acquisition of more assets and, consequently, potentially higher profits.

Risks Associated with Leverage

Symmetrical Amplification of Gains and Losses

Leverage can magnify profits, but it equally intensifies losses.

This symmetry means that any market downturn will lead to amplified losses, which can disproportionately affect leveraged portfolios.

Risk of Ruin

The critical downside of leverage is the increased risk of portfolio ruin.

Leveraged portfolios not only suffer greater losses during downturns but also face higher risks of failing to survive financial lows.

There’s a wide range of outcomes in the distribution of a portfolio.

Leverage, used inappropriately, can narrow the window of acceptable outcomes.

Role of Volatility and the Dangers of Complacency

Impact of Market Volatility

Even temporary market downturns can devastate highly leveraged portfolios if such conditions lead to credit cutoffs, investor withdrawals, or forced sales triggered by breaches of regulatory or contractual obligations.

Underestimation of Tail Risks

Traders typically base leverage decisions on “normal” volatility levels, observed through historical data.

Nonetheless, infrequent extreme market events, or “tail events,” can precipitate severe losses, often following periods of apparent stability and increasing complacency among investors.

For example, if you had looked at a chart of residential real estate in the US from 1900-2006, it seemed like a fairly benign thing.

Residential housing went up by about the rate of inflation with some cyclicality due to the debt- and interest rate-sensitive nature of it, but nothing calamitous.

Banks/underwriters and consumers extrapolated the past without deeply understanding what they were doing because they had never experienced it before or understood what their actions were leading toward.

The resultant bubble – which made it seem like everything was amazing and to do more of the same – and subsequent collapse nearly wiped out the financial system, as the leveraged price falls swamped the equity of key institutions and financial intermediaries.

If a bank is leveraged 30x (which was normal at the time) it only takes about a ~3% fall in value in the asset base to render the institution nearly insolvent.

Psychological Factors and Market Misjudgments

False Sense of Security

Nassim Nicholas Taleb makes the use of the Russian roulette analogy for financial leverage in Fooled by Randomness.

In financial markets, the “fatal bullet” of extreme loss tends to manifest rarely.

This leads to a numbing false sense of security among traders/investors.

Invisibility of Risk

Unlike the clear and present danger in Russian roulette, the risks in financial markets are not always visible or easy to quantify.

This invisibility can lead traders to engage in what is effectively an extremely risky financial version of Russian roulette, often without recognizing the true risk.

Historical Bias and Outlier Neglect

Traders generally expect future outcomes to align closely with historical norms.

But this expectation can lead to an underappreciation of potential outliers, including events that are rare or unprecedented.

Recent crises show the importance of considering “once-in-a-century” outcomes (or things that have never happened before) in risk management strategies.

Cyclical Nature of Risk Attitudes

Trader Psychology and Market Influence

The short-term dynamics of the market are influenced by investor psychology, which tends to be cyclical.

These cycles can drive market valuations to irrational highs and then correct to irrational lows, as attitudes and extrapolations of recent conditions toward risk fluctuate.

Impact on Leverage Use

During periods of positive market performance, the perceived benefits of leverage, such as enhanced returns from increased trading capacity, are emphasized.

This favorable view leads to an increased adoption of leverage across the financial community.

The Cycle of Leverage Adoption and Reversal

Expansion Phase

When markets perform well, the following trends typically occur:

• Recognition of leverage’s benefits increases.
• Risks associated with leverage are underestimated or ignored.
• Traders are more inclined to employ leverage.
• Lenders are more willing to extend credit.
• Regulatory and social beliefs surrounding leverage use become more relaxed.

Contraction Phase

When market conditions deteriorate, the cycle reverses:

• Leverage is seen as a liability rather than an asset.
• Lenders restrict credit and demand repayment, exacerbating financial stress for borrowers.
• Regulatory and market pressures increase, often tightening the conditions under which leverage is used.

Psychological Extremes and Market Corrections

Behavioral Extremes

The psychological shifts from optimism to pessimism about leverage are typically extreme relative to the economic fundamentals…

…moving from overly permissive to excessively restrictive.

These extremes can lead to market adjustments and can amplify the impact of market downturns.

Role of Leverage in Market Panics

Historical observations, such as those noted by Manchester banker John Mills in 1865, suggest that market panics (what are known as recessions today) don’t necessarily destroy capital but reveal the extent to which it’s been already damaged by excessive leverage in prior booming periods.

In other words, the real damage occurs during the boom through imprudent accumulation of debt, which only becomes apparent during a crisis.

Optimal vs. Maximum Leverage

Rational Leverage Approach

In terms of strategy, leverage is more about optimization rather than maximization.

There’s also the concept of deleveraging – i.e., if assets as they come pre-packaged to you are too risky for your tastes.

For example, let’s say a trader wants to own the NASDAQ but its ~24% annual volatility is too high and they want something closer to 18% volatility.

So, for every $3 in NASDAQ they buy, they can hold an extra $1 in cash against it (instead of $4 and $0).

Limitations on Leverage

Traders are often tempted to use the maximum available leverage, especially when optimistic about potential gains.

However, prudent trading requires using what’s realistic to allow for unforeseen negative outcomes and to maintain stability.

Leverage, Volatility, and Risk Management

Risk Assessment

Accurate leverage use demands an assessment of associated risks.

It’s important to base leverage decisions on conservative and cautious assumptions, especially when dealing with more volatile or higher-risk investments.

For example, stocks are already a leveraged investment (companies have debt).

Margin of Safety

As emphasized by Warren Buffett, maintaining a “margin of safety” is essential.

Using all available leverage may optimize potential returns but undermines the safety margin needed to make sure you can survive market corrections or downturns.

Avoiding Excessive Risk

The risk profile of the underlying assets should dictate the extent of leverage used.

Riskier investments warrant less leverage.

Bonds can be made competitive with equities through leverage.

Likewise, lower-returning public equity can be made competitive with private equity through leverage (because private equity is typically leveraged and commands an additional premium due to its illiquidity).

Philosophical and Practical Perspectives on Debt

Longevity in Trading

Drawing parallels to Morgan Housel’s observations on enduring businesses, the goal of using debt in trading should align with achieving longevity and sustainability, rather than merely maximizing short-term gains.

This goes back to the shinises mentioned earlier.

Adage

The saying, “There are old investors, and there are bold investors, but there aren’t many old bold investors,” captures the essence of cautious leverage use.

There’s the need for a balance between ambition for higher returns and the necessity of preserving capital over the long term.

Conclusion

Using a moderate amount of leverage can be a strategic approach that balances the pursuit of enhanced gains with the imperative to protect against adverse market movements.

This balanced, measured approach doesn’t just give you a shot at solid gains when the markets are cooperating, but it also protects your nest egg or trading bankroll when storms inevitably roll in.

By playing it smart and fairly conservatively, you increase your chances of being in the game for the long haul.