Leverage, shorting and risk

Leverage: trading with borrowed money

Leverage means controlling more than you own. The most common way for an individual is a margin account: your broker lends you money to buy securities, using the securities themselves (and anything else in the account) as collateral, and charges interest on the loan.

Say you have $10,000 and borrow another $10,000 to buy $20,000 of stock. That is 2x leverage. If the stock rises 10%, your holding is worth $22,000; you still owe $10,000, so your own money has grown to $12,000, a 20% gain. If the stock falls 10%, your holding is worth $18,000, you owe $10,000, and you have $8,000: a 20% loss. Leverage multiplies both directions, and you pay interest on the loan whether the trade works or not.

In the US, the Federal Reserve's Regulation T generally lets you borrow up to 50% of the purchase price of stocks, which is where the 2x figure comes from. Other products build leverage in: futures, options and leveraged funds can give far more exposure per dollar than a margin account, and some brokers outside the US offer much higher leverage on contracts tied to stock prices.

Margin calls

The broker's main worry is that you lose more than your own money and can't repay the loan. So after you buy, you must keep a minimum amount of your own money in the position, called maintenance margin. FINRA's rules set the floor at 25% of the market value of the stocks held long, and brokers commonly set their own, higher requirements, especially for volatile stocks.

If losses push your equity below that level, you get a margin call: deposit more money or sell. The part people miss is that the broker does not have to wait for you. Margin agreements allow the broker to sell your holdings without asking, at whatever the price is at that moment, and to choose which holdings to sell. You can be forced out at the bottom of a fall that later reverses, turning a temporary loss into a permanent one. In a fast enough drop, the sale can happen below the point where your equity is gone, and you owe the broker the difference.

Press New year a few times at 1x and then at 3x or 4x. The unleveraged account has good and bad years. The leveraged one has a much wider spread of outcomes, and on bad paths it doesn't just lose more: it gets closed out partway through, and misses any recovery that follows. Leverage changes not only how much you make or lose, but whether you are still in the game.

Short selling: betting on a fall

To profit from a price falling, you sell short: borrow shares from someone who owns them (your broker arranges this, usually from other customers' margin accounts or from institutions that lend out their holdings), sell them now, and later buy the same number back to return. Sell at $100, buy back at $70, and you keep $30 a share, minus costs.

The costs and risks are different from buying:

• The loss has no ceiling. A stock you buy can fall at most to zero. A stock you short can rise without limit, and you have promised to buy it back whatever it costs.
• You pay to borrow. Shares that are easy to borrow cost little. Shares many people want to short can cost a high annual fee, and that fee can rise while you hold the position. If the lender wants the shares back and no others can be found, you can be forced to buy back early.
• You pay the dividends. While you are short, any dividend the company pays goes to the person who lent you the shares, and it comes out of your account.
• Margin works against you as the price rises. A rising price increases what you owe and shrinks your equity, so a short squeeze and a margin call often arrive together.

Short squeezes

When a lot of people are short the same stock, a rising price forces some of them to buy back, either to cut losses or because of margin calls. Their buying pushes the price higher, which forces more of them to buy. This feedback loop is a short squeeze.

The best-known recent example is GameStop in January 2021. The stock was one of the most heavily shorted in the market, with reported short interest above the number of shares available to trade. Retail traders, many organised on online forums, bought shares and call options. The price went from under $20 at the start of the month to an intraday high above $480 on 28 January. Some hedge funds that were short lost billions; one needed an emergency investment from other firms. Several retail brokers then temporarily restricted buying in the stock, largely because the clearinghouse that guarantees trades (chapter 5) demanded much larger deposits from them as risk soared. Within weeks the price had fallen most of the way back, and many who bought near the top lost heavily too.

Volatility drag

Here is a risk that has nothing to do with borrowing. If an investment rises 50% and then falls 50%, you have not broken even. $100 becomes $150, then $75. The average of the two returns is zero, but you lost a quarter of your money. Losses and gains are not symmetric because each one is a percentage of a different starting amount.

This is called volatility drag, and it is always there: the more an investment swings, the further its actual compounded growth falls below its average return. A useful approximation is that the long-run growth rate is roughly the average return minus half the variance. For a broad stock index the drag is modest. For a single volatile stock it is large. For anything leveraged it is larger still.

Leveraged funds and the daily reset

Leveraged exchange-traded funds aim to deliver two or three times the daily return of an index, and some deliver the inverse. Each day they rebalance to get back to their target leverage. Over one day they do what they say. Over months, the results can be very different from two or three times the index's return, because the fund compounds a magnified version of every daily swing. In a choppy market that ends where it started, a 3x fund can lose a large fraction of its value. US regulators have repeatedly warned that these funds are designed for short holding periods.

Drawdowns, and why sizing matters more than picking

A drawdown is the fall from a peak to a low. Because of the same asymmetry as volatility drag, deep drawdowns need enormous gains to recover:

Gain needed to recover from a loss

If you lose	You need to gain
10%	11%
20%	25%
33%	50%
50%	100%
75%	300%
90%	900%

This is why professional traders talk more about position sizing than about picking winners. If a single bad trade can only cost 1% or 2% of the account, a long losing streak is survivable and the occasional good idea gets a chance to pay. If a single trade can cost half the account, one bad call can end it. A strategy that is right more often than not can still go broke if it bets too much each time; there is a mathematical result about this (the Kelly criterion) showing that past a certain bet size, betting more lowers your long-run growth even when every bet has a positive expected value.

Options, briefly

An option is a contract giving the right, but not the obligation, to buy (a call) or sell (a put) a stock at a set price before a set date. In the US, one contract usually covers 100 shares. Buying options is a form of leverage: a small premium controls a large position, and if the stock doesn't move far enough, fast enough, the whole premium is lost. Selling options can carry the same unlimited risk as short selling. Options also have legitimate defensive uses, such as buying a put as insurance on a stock you own. They deserve a site of their own; the point here is that every route to bigger gains per dollar comes with bigger losses per dollar, and usually with a way to lose everything.

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